Managerial Finance Version 1.1 1st Edition by Amy K. S. Scott SOLUTIONS MANUAL

Chapter 1 Why Finance?

Case Study – If Only . . . 

How do individuals and businesses make choices in a world of scarce resources?

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How can individuals and business fund their choices?

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For example . . . o How can a farmer obtain funds to purchase milk cows to feed her family and ultimately her neighbors? o How can a tailor obtain the funds to advertise and move to a more prominent store front? o How can a CEO decide which product lines to expand?

Section 1. Finance in the World 

Describe finance.



Define the three branches of finance.

Section Outline What is finance? 

Finance is the application of economics, allowing for the tradeoff of various resources in the face of uncertainty, particularly over time. An economist’s primary tradeoff is supply vs. demand, while a financier’s is risk vs. return.

What are the three main branches of finance? 

Personal Finance: The decisions made by individuals about their own money.

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Public Finance: The study of the income and expenditures of the government.

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Managerial Finance: The financial decisions made by managers of companies for the purpose of operating a business.

© 2019 FlatWorld

Key Takeaways 

Finance is related to economics. An economist looks at supply vs. demand. A financier looks at risk vs. return.



The three branches of finance are personal, public, and managerial.

Key Terms     

Economics: The study of scarcity; how individuals and groups utilize scarce resources.

Finance: The application of economics.

Personal Finance: The decisions made by individuals about their own money.

Public Finance: The study of the income and expenditures of the government.

Managerial Finance: The financial decisions made by managers of companies for the purpose of operating a business.

Answers to Exercises 1. Personal finance, public finance, and managerial finance. Answers to second part will vary.

Section 2. Finance in Business 

Explain the role of finance in business.



Discuss the types of organizations that need financial management.

Section Outline

The role of finance in business 

Financial management involves the successful day to day management of cash to ensure there is enough to pay the bills. Strategically, financial managers are involved in planning © 2019 FlatWorld

discussions about the future direction of the business. Inclusion of financial matters in these discussions is vital otherwise the plan may not have funding. 

Finance is involved in everything from the daily operations to the long-term five-year strategic plans of an organization.

Ownership structures of business 

Sole proprietorships are single owner, typically smaller, companies. They are easiest to establish, because the owner (proprietor) is just one person who is typically involved with the operation of the business.

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Partnerships are companies where two or more owners have a legal agreement to share liability. o Limited partners are not engaged in the day-to-day operations; their liability is limited to their contributed capital. o General partners are owners in a partnership who participate in the day-to-day operations of the business and have unlimited liability.

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Corporations are legal entities distinct from their owners, providing limited liability protection.

Key Takeaways 

Successful financial management is vital to a company to ensure continued operation.

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All types of organizations need financial management.

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The three types of companies based on ownership are: sole proprietor, partnership, and corporation.

Key Terms      

Sole proprietorships: Single owner, typically smaller, companies.

Partnerships: A company where two or more owners have a legal agreement to share liability.

Limited partners: Owners in a partnership whose liability is limited to their contributed capital.

General partners: Owners in a partnership with participation in the day-to-day operations of the business and unlimited liability.

Corporations: Legal entities which are distinct from their owners, providing limited liability protection.

Shareholders: Owners of a corporation. © 2019 FlatWorld

Answers to Exercises 1. Examples include: financial plans, investment decisions, income and expense budgeting, long-term strategic plans.

2. Sole proprietorships, partnerships, and corporations.

Section 3. The Role of the Financial Manager   

Understand the different titles of a firm's financial managers.

Explain the many different financial functions in an organization.

Demonstrate how finance impacts other areas of the business.

Section Outline Chief Financial Officer (CFO) 

The CFO is ultimately responsible for all financial decisions.

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The CFO reports to the Chief Executive Officer (CEO) and the board of directors (or, in a privately owned company, to the owners themselves).

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Two financial managers report to the CFO, the treasurer and the controller.

Treasurer

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The treasurer is the firm's chief financial manager responsible for external financial activities.

Finance Functions 

Under either the controller or treasurer, analysts and staff accountants have a specific finance-related function in the organization.

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Many large organizations have entire departments whose focus is to make money using company funds or manage risk.

The Impact of Finance 

Compensation is based on financial performance.

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Compensation depends on understanding of how one’s role impacts the bottom line of the company.

© 2019 FlatWorld

Key Takeaways 

The CFO, Treasurer, and Controller are the top financial positions.

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Understanding finance is essential for success in many other areas of the business, even if only for your own compensation.

Key Terms   

Chief Financial Officer (CFO): The top financial officer in larger public companies, as well as many smaller companies.

Treasurer: Financial manager in charge of externally focused items such as financial planning and fundraising.

Controller: Financial manager in charge of internally focused items such as accounting statements and tax statements.

Answers to Exercises 1. a. Treasurer: in charge of external financing such as financial planning and raising funds b. Controller: in charge of internal items such as accounting statements and tax statements c. CFO: ultimately responsible for all financial decisions and reports to CEO 2. Answers may vary, but examples include: needing to raise funds to launch a new product, lack of funds influencing benefits in a human resource department, operations need to reduce costs while maintaining quality, etc.

Section 4. End-of-Chapter Exercises Answers to Exercises 1. Similar: owners of the business, lack of survivability, general partners and sole proprietors have liability for company Different: one owner vs. many owners, limited liability partners don’t have the same liability, tax treatment can be different (passive losses) © 2019 FlatWorld

2. Similar: owners of the business Different: one owner vs. many owners, usually different tax treatment, shareholders can have limited liability, corporation can survive death of owners, corporations are a legal entity 3. Similar: multiple owners of the business, limited liability partners are like shareholders re: liability Different: corporation can survive death of owners, usually different tax treatment, corporations are a legal entity

© 2019 FlatWorld

Chapter 2 Ethics and Finance One Bad Apple 

Finance scandals date back to the Medici family in 1492; the Madoff scandal is simply one of many examples throughout history.

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Given the importance of trust when dealing with matters of money, finance professionals should strive for a higher ideal: to do what is right and just.

Section 1. Ethics Foundations 

Define and discuss a working concept of ethic.

Describe the four main categories of approaches to ethics.

Section Outline What is ethics? 

Ethics is a system of evaluating whether an action is right or wrong.

What are the main categories of approaches to ethics? 

Outcome based (consequentialism): the possible outcomes (consequences) of actions are determined, and the most desirable of the outcomes chosen.

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Universal rules (deontology): the “duty” of the actor is to abide by a governing set of rules.

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Character based (virtue ethics): how an individual’s actions reflect upon their identity and moral standing drives what is proper.

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Social norms (pragmatic ethics): behaving in ways acceptable to the bulk of society.

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Which is best? While this is a personal choice, organizations and firms will often hold their employees to a standard more stringent than the law.

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Legal vs. Ethical 

In most ethical systems, legal actions are not necessarily ethical.

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In finance, many companies have a “Code of Ethics” which employees are supposed to follow.

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The CFA Institute maintains a Code of Ethics & Standards of Professional Conduct its members are obliged to hold.

Key Takeaways 

Ethics are a framework to determine what is right from what is wrong.

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Legal ≠ Ethical. Actions can be illegal but ethical or legal but unethical.The three branches of finance are personal, public, and managerial.

Key Terms 

Ethics: A system for evaluating whether an action is right or wrong.

Answers to Exercises 1. Answers will vary depending upon ethical frameworks used. The purpose of this question is not to arrive at a “yes” or “no” answer, but to stimulate discussion.

2. Answers will vary. Some possibilities: a. Outcome based: perhaps “yes”, as slavery of a few might provide better outcomes for the remaining if looking to maximize overall utility, but could be “no” if looking to maximize the utility of the worst off (to use two possible systems). b. Universal rules: again, “yes” or “no” depending. If the rule is “nothing without consent”, for example, than clearly “no”. c. Character based: depends upon which virtues are used. d. Social norms: again, could be either depending upon the society.

3. Answers will vary. “Honesty” is less important than “a good grade” (or perhaps “not wanting to work”) for that individual, and there are ethical systems that could frame this as proper or improper.

© 2019 FlatWorld

Section 2. Ethics in Finance 

Explain the concept of fiduciary duty.

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Discuss examples of ethical issues that arise in finance.

Section Outline

Fiduciary duty 

Finance professionals are often charged with putting the client’s interests above their own.

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While fiduciary duty is defined within the laws, there exist situations where no legal burden exists but an ethical burden resides. o A financial manager must weigh bondholder and shareholder interests when selling assets to meet interest payments. o An accounting strategy may consider the impact on the government.

Key Takeaways 

Fiduciary duty can obligate a manager to put another’s interests ahead of one’s own.

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While numbers are important, it is equally important to think about context and what lies beyond.

Key Terms 

Fiduciary duty: The requirement to put another’s interests (especially financial) before personal interests.

Answers to Exercises © 2019 FlatWorld

1. He might have an obligation. It would depend upon his arrangement with his clients, the rules of regulators, the policies of his company, etc. If he has a fiduciary duty, due to any of the above, it is much more likely that he has the obligation. Additionally, if he invests his money, and then advises his clients to also invest, he could be accused of “front running” his clients if he doesn’t at least disclose his involvement.

2. Similar to answer above. If he has a fiduciary duty, he probably needs to advise his clients before pulling out any of his own money from the investment.

Section 3. Ethics in Management  

Explain the agency problem.

Describe the stakeholder relationship and enumerate key stakeholders.

Section Outline The agency problem 

An agent is expected to act on behalf of the principal.

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The agency problem occurs when an agent has incentives to act in one’s personal interest over the principal’s.

Responsibility to stakeholders

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As agents have responsibilities to the principal, management has a responsibility to stakeholders: all affected by operations of the company. o The narrowest view endorses maximizing shareholder profit as the dominating factor. o A broader view would encompass employees, suppliers, customers, investors, communities, their governments, and even competitors. o Regardless of the view, one guideline exists: human dignity is paramount.

Key Takeaways 

One solution to the agency problem is to align incentives of the agent with the incentives of the principal.

© 2019 FlatWorld

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Stakeholders can include employees, customers, suppliers, investors, communities (and their governments), and potentially even competitors!

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Maintaining human dignity should always factor into a management decision.

Key Terms    

Agency: A relationship in which one party (the agent) is expected to act on behalf of another party (the principal).

Agency problem: A situation where an agent has incentives to place personal interest over the principal’s.

Stakeholders: Parties affected by the operations of the company.

Answers to Exercises 1. If ABC is making a key part for DEF, then DEF might be dependent upon ABC. Since DEF buys so much of ABC’s output, if ABC can’t easily sell elsewhere, DEF might have a lot of influence (over pricing, for example). They are stakeholders in each other, since each might depend upon the other’s continued business.

2. If it is an unnecessary use of resources for little benefit, it might be against shareholder desires. But if it allows the CEO to be more efficient with his time, or is cheaper than commercial travel, or causes the CEO to accept less salary, then it might be in line with shareholder desires.

3. Other factors in favor of selling might include: does it provide benefits that aren’t available with existing drugs, such as extending life or improving quality of life, or can the side effects be mitigated. Other factors to not sell might include: considering the ethics of the situation, considering the potential government response, or thinking about the possible negative publicity.

Section 4. International Considerations 

Discuss how globalization can cause ethical conflicts.

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Section Outline Ethical conflicts 

Differences exist because of political systems, law, economic development and culture.

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One must balance one’s ethical system when dealing with other’s culture and legal systems.

Key Takeaways 

Globalization creates new ethical considerations.

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Culture plays a role in ethical financial decisions.

Answers to Exercises 1. Current employees might have to take lower salaries due to the increased foreign competition, or they might be able to transition to more valuable positions within the company due to increased demand of the product. Potential employees in the new country are most likely to benefit from the increased job opportunity. Customers will benefit from the lower cost, and suppliers might benefit from increased demand in raw materials. The government might benefit by the increased tax revenue, and the investors will benefit from the increased profits.

2. Some might see it is a bribe, and unethical. Others might see it as a “facilitating payment”, since the official isn’t doing something that they wouldn’t do otherwise.

Legality of such an arrangement probably depends upon jurisdiction. Whether or not it is ethical probably depends upon the system being used and other specifics of the case, such as if the payment will give the company an advantage over a competitor.

3. Much will come down to the assumptions about the specifics of what the byproduct does and the ethical framework being used. For example, maybe the byproduct is being banned because it harms wildlife in the current country that isn’t present in the neighboring country. Or maybe the neighboring country has available land that is far enough away from the harmed organisms, or has water treatment facilities available to filter out the byproduct.

4. Answers will vary. Consider, for example, if the multinational gives working conditions that are superior to what is currently in the foreign country (e.g. higher wages or better © 2019 FlatWorld

hours) but still inferior to the home country. Or if pollution will be worse, but workers will get a higher quality of life from the increased wages. There are many potential tradeoffs, and the assumed specifics will often influence the ethical calculus.

Section 5. The Bigger Picture 

Explain how decisions have both financial and ethical considerations.

Section Outline The “bottom line” isn’t the only consideration 

Financial problems often have quantifiable components important to the decision making process.

Impact upon the “bottom line” is a key consideration, but it is not the only consideration; relying upon one or two numbers to justify a business decision is usually too narrow in scope.

Key Takeaways 

Even simple decisions can have far reaching ethical implications.

Answers to Exercises 1. Answers will really vary. For some, the worker being a friend would raise their value relative to strangers. For others, the friend might be presumed to be more willing to sacrifice “for the good of the many”. Similar arguments for the mother. Students should try to justify their answers using an ethical system and explain which type of system it is.

2. Answers can vary, but here are some example answers a. Underage drinking breaks a law, and laws should be followed unless they are proven to be unjust. (Universal rules) b. Everybody knows that underage teens drink, so it isn’t a big deal. (Social norms) c. Underage drinking, if done moderately, brings joy to those who partake, raising the overall utility of society. (Outcomes based) © 2019 FlatWorld

3.

4.

5.

6.

d. “Law abiding” is a valued character trait, and more important than “fun loving”.

(Character based).

That the character values money (or perhaps the act of making a sale) more than most other virtues (at least, more than “filial charity”).

Jill has materially useful information about the car that would probably affect Jack’s valuation. Jack might still value the car more than $300 if Jill discloses the issue, but he might no longer be interested. Many states actually have laws governing the disclosure of such information, so that would be another consideration. Is Jill being honest if she doesn’t disclose the information? Is she being just?

A lot depends upon the circumstances. Maybe the displaced worker could be given a different position. Perhaps a competitor has increased product quality, and without the better machine the survival of the company could be in question. Or perhaps the increased quality will increase the value to the customers (trading off the value to the customer stakeholder with the employee stakeholder).

This is a very complex issue, and one that many companies still struggle with today.

There are issues with how much children should be allowed to decide for themselves, what the alternatives are (are they missing schooling that would help to better their future), and what the headline risk is in the home country (will customers still buy the product if word gets out). This is just the tip of the iceberg, and much discussion can be had on this issue.

© 2019 FlatWorld

Chapter 3 Financial Statements Communication . . . 

In addition to a marketing plan and public relations, firms communicate to the public through their financial reports.

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Firms complete statements in accordance with generally accepted accounting principles (GAAP).

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Public companies must submit a 10-K, which include a balance sheet, statement of cash flows, and an income statement.

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Also submitted are the annual report to shareholders with a letter to the shareholders.

Section 1. The Income Statement 

Describe what an income statement is.

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Explain how to read an income statement.

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Describe what factors influence the income statement.

Section Outline Income Statement 

The income statement displays revenues, costs, and the “bottom line”: net income.

Revenues to Gross Profit 

The “top line” of the income statement is revenues (also called sales or sales revenues).

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To arrive at gross profit, cost of goods sold (COGS) are deducted from revenues.

Gross Profit to Net Profit © 2019 FlatWorld

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Operating profit is gross profit less all operating expenses.

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Operating expenses include selling, administrative, and general expenses (SG&A) and leases. Deducting these from gross profit is EBITDA: earnings before interest, taxes, depreciation and amortization.

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Operating expenses also include depreciation and amortization.

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Operating profit is also called EBIT: Earnings Before Interest and Taxes.

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Net Profit Before Taxes equals EBIT minus interest paid.

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Net Profit (or Net Income) is revenue minus expenses, depreciation, interest and taxes.

Key Takeaways 

Income statements provide a moving picture of a company's financial position over a period of time.

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An income statement includes revenues earned and expenses paid (or not yet paid) and the bottom line to the investors: net income.

Key Terms           

Revenue: Income or the amount of money received by a company during a specific period. Typically, price times quantity sold.

Cost of goods sold (COGS): Direct costs attributable to the production of goods or services including raw materials and labor.

Gross profit: Revenue less cost of goods sold.

Operating expenses: Expenditures that result from normal business operations.

Depreciation: A way to allocate the cost of an asset over its useful life.

Amortization: Paying off a debt in regular installments over time.

Earnings before interest, taxes, depreciation and amortization (EBITDA): Gross profit less SG&A and leases.

Operating profit: Gross profit less all operating expenses.

Net profit before taxes: Revenues minus all expenses except taxes.

Net income: A company's total profit calculated by revenue minus expenses, depreciation, interest and taxes.

Profit: The financial gain when revenue exceeds costs.

Answers to Exercises © 2019 FlatWorld

1. Students should post screenshots or the like showing that they found the required elements.

2. Income Statement: Revenues COGS Gross Profits SG&A Depreciation Total Operating Expenses Operating Profit (EBIT) Interest Net profit before taxes (EBT) Taxes Net income

$ 200,000 $ 70,000 $ 130,000 $ 30,000 $ 35,000 $ 65,000 $ 65,000 $ 20,000 $ 45,000 $ 9,450 $ 35,550

Section 2. The Balance Sheet 

Describe what a balance sheet is.

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Explain how to read a balance sheet.

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Describe what factors influence a balance sheet.

Section Outline

Balance Sheet 

Assets=Liabilities + Equity (or Shareholder Equity)

Assets 

Assets are divided into current and fixed assets.

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Current assets include all assets expected to be converted to cash within one year.

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Current assets normally include cash, inventory, and accounts receivable.

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Fixed assets, building, machinery, and land, are assets not expected to be converted in one year. © 2019 FlatWorld

Liabilities 

Current liabilities are payments due within one year, including loans, accruals, notes payable and accounts payable.

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Long term debt includes all long term loans.

Equity 

Equity is comprised of shareholders’ equity and retained earnings.

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Shareholders’ equity is the amount received from selling equity.

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Retained earnings are the cumulative sum of all profits not distributed to shareholders.

Key Takeaways 

A balance sheet is a snapshot of a company's financial position.

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Balance sheet lists assets on the left side and liabilities and shareholders’ equity on the right.

Key Terms         

Assets: A resource the firm owns.

Liabilities: A company's debts or legal obligations to creditors.

Shareholders’ equity: The residual claim of a firm held by the firm's owners.

Liquidity: Ease with which an asset can be converted to cash.

Book value: Values used on the balance sheet, determined by accounting rules, that might differ from actual market value.

Current assets: Items such as cash, accounts receivable and inventory that can be expected to be converted to cash in under one year.

Fixed assets: Items such as buildings, machinery, land and patents not expected to be converted to cash in under one year.

Current liabilities: Items such as accounts payable and accruals that are expected to be paid in under one year.

Retained earnings: Cumulative earnings not yet paid out as dividends but retained by the firm to pay its debt or re-invest in the firm.

Answers to Exercises

© 2019 FlatWorld

1. Students should post screenshots or the like showing that they found the required elements.

2. Balance Sheet: Assets Current assets Fixed assets Total Assets

Liabilities and Equity Current Liabilities Total Liabilities Equity Total Liabilities and Equity

80,000 40,000 120,000

95,000 95,000 25,000 120,000

Section 3. Cash Flow Statement   

Describe what a statement of cash flows is.

Explain how to read a cash flow statement.

Describe what factors influence a cash flow statement.

Section Outline Statement of cash flows 

Summarizes cash flows over the time reported.

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The statement is separated into operating cash flows, investing cash flows, financing cash flows.

Key Takeaways 

The statement of cash flows consists of cash from operating, investing, and financing activities.

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Cash from operations measures how well a company generates cash from making and selling its product.

Key Terms

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   

Statement of cash flows: A summary of cash flows over a period of time reported.

Operating cash flows: Revenues generated from the operations of a company.

Generally defined as revenues less all operating expenses.

Investing cash flows: Cash flows received from investments such as the buying and selling of fixed assets in our own firm or financial investments in other firms.

Financing cash flows: Cash flows to or from investors.

Answers to Exercises

1. Students should post screenshots or the like showing that they found the required elements.

2. Students should post screenshots or the like showing that they found the required elements.

3. Statement of Cash Flows: Cash provided by operating activities Cash provided by investing activities Cash provided by financing activities Net cash increase

$ 50,000 $ 30,000 $ 45,000 $ 125,000

Section 4. Other Statements  

Define additional financial statements such as the statement of shareholders’ equity.

Understand the importance of these additional financial statements and the information they provide.

Section Outline Statement of Shareholder Equity 

Describes changes to company’s equity section of balance sheet over a year.

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Includes any equity transactions such as retained earnings, common and preferred stock and other income.

© 2019 FlatWorld

Statement of Retained Earnings 

Reports changes in retained earnings over the year.

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Retained earnings is the net income not distributed to shareholders.

Notes to Financial Statements 

Includes management discussion and analysis (MD&A) and notes to financial statements.

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Notes to financial statements explain transactions including taxes, revenues, fixed assets, pension plans, stock options and debt terms.

Key Takeaways 

Sometimes the most important information is not in the main financial statements. Be sure to look at all of the financial information - especially the notes! Management will explain (or try to explain!) the company's actions in places other than the main financial statements.

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Statement of shareholder equity describes any changes to the equity section of a firm's balance sheet over a year.

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Statement of retained earnings reports the change in retained earnings over the year.

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The notes to financial statements are also very important as they contain explanations about certain financial actions taken by the company.

Key Terms    

Statement of shareholder equity: A consolidated statement defining the changes to a company's equity position over a year.

Statement of retained earnings: Abbreviated statement that states the changes to retained earnings over a year.

Management discussion and analysis (MD&A): Further discussion in the financial statements about last year's performance, as well as any goals or changes for the next year.

Notes to financial statements: Extended description and analysis of items included in the financial statements.

© 2019 FlatWorld

Answers to Exercises 1. Students should post screenshots or the like showing that they found the required elements.

2. Students should post screenshots or the like showing that they found the required elements.

Section 5. Taxes  

Compare and explain marginal and average tax rates.

Calculate average and marginal tax rates.

Section Outline Corporate taxes 

Recently changes to a 21% flat tax on January 1, 2018.



Two important concepts: average tax rate, the tax bill divided by taxable income, and marginal tax rate, the rate applied to the last dollar of income.

Depreciation 

Equipment or property costs are allowed to be deducted from taxable income over its useful life.

Key Takeaways 

Successful management of a company's taxes can have important financial impacts.

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Average tax rate is total taxes divided by taxable income.

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Marginal tax rate is the rate at which the last dollar of income was taxed.

Key Terms 

Average tax rate: The total amount of taxes paid divided by taxable income. © 2019 FlatWorld

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Marginal tax rate: The taxes paid on the last dollar of income earned.

Answers to Exercises 1. The average tax rate is the amount paid relative to the total taxable income. The marginal tax rate is the amount paid on the next dollar of taxable income.

2. a. Taxes paid: $113,900+.34*($600,000-$335,000)=$204,000; Average: $204,000/$600,000=34% ;Marginal: 34% b. Taxes paid: $113,900+.34*($1,737,500-$335,000)=$590,750; Average: $590,750/$1,737,500=34% ;Marginal: 34% 3. a. Taxes paid: $600,000*.21=$126,000; Average: $126,000/$600,000=21% ;Marginal: 21% b. Taxes paid: $1,737,500*.21=$364,875; Average: $364,875/$1,737,500=21% ;Marginal: 21%

Section 6. Cash Flow   

Identify the difference between types of cash flows.

Explain depreciation as a non-cash item.

Define and calculate operating cash flow.

Section Outline Non-cash item: Depreciation 

Depreciation does not affect our cash position.



Depreciation does lower net income because it is subtracted from taxable income.

Cash Flow 

Separated into operating, investing, and financing activities



Operating cash flows (OCF) is after tax operating income plus depreciation: EBIT(1T)+Depreciation

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Free cash flow is cash available to investors. It is equal to operating cash flows minus any new capital spending and change in net operating working capital. © 2019 FlatWorld

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Net operating working capital (NOWC) is current operating assets (cash + accounts receivable + inventories) minus current operating liabilities (accounts payable + accruals).

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FCF=OCF – capital spending – change in NOWC.

Free Cash Flow Example 

Free Cash Flow is calculated for a fictional company, CABS.



Operating cash flows, capital spending, and change in net working capital are calculated in order to obtain free cash flow.

Key Takeaways 

Calculating free cash flows can be a bit tricky - but it is vital. Start with operating cash flows and then make adjustments for changes in capital spending (gross fixed assets) and net operating working capital.



Operating cash flow is the cash left over from operations. Its calculation is: EBIT(1-Tax Rate)+Depreciation.



Free cash flow is the actual amount left over for investors. It is operating cash flow adjusted for changes in capital spending and net working capital.

Key Terms     

Operating cash flow (OCF): Cash earned from daily operations of selling our product.

Free cash flow (FCF): Cash available to investors.

Capital spending: Purchase of fixed assets less any sale of fixed assets. he total amount of taxes paid divided by taxable income.

Net operating working capital (NOWC): Current operating assets (Cash + Accounts Receivable + Inventories) minus current operating liabilities (Accounts Payable + Accruals)

Answers to Exercises 1. Operating cash flows, investing cash flows, and financing cash flows.

2. © 2019 FlatWorld

a. Investing cash flow b. Investing cash flow c. Investing cash flow d. Investing cash flow e. Operating cash flow 3. Since depreciation is a non-cash expense, and EBIT was calculated by removing depreciation, we need to add the amount of depreciation back into the calculation to get the actual effect on cash.

4. (Assuming no depreciation!) OCF=$65 million * (1-.40) + $0 = $39 million; FCF = $39 million - $45 million - (-$30 million) = $24 million

Section 7. Ratio Analysis  

Understand how to analyze financial statements.

Use the categories of ratios to gain knowledge about the strength of a company.

Section Outline Ratio analysis is an important tool in evaluating a company’s health.

Ratios are divided into categories depending on what they analyze.

Liquidity Ratios 

Liquidity ratios measure the ability to meet short-term financial obligations.



Current ratio: Current assets/current liabilities.



Quick ratio (Acid test): (Total current assets-inventories)/Total current liabiltiies.

Asset Management Ratios 

Asset management ratios measure how well a firm uses its assets.



Inventory turnover ratio: Cost of goods sold/average inventory. A measure of efficiency.



Average payment period: Accounts payable/average purchases per day.



Receivables turnover ratio: Sales/average receivables. A measure of how effective does a firm collect money owed to them.



Total asset turnover ratio (TAT): Sales/total assets. How effectively a firm leverages its assets.



Fixed asset turnover ratio (FAT): Sales/fixed assets. How effectively a firm leverages its assets. © 2019 FlatWorld

Debt Management Ratios 

Debt management ratios measure how much a firm uses debt as a source of financing.



Debt ratio: Total liabilities/total assets.



Debt-equity ratio: Total liabilities/total equity.



Equity multiplier: Total assets/total equity.



Times-interest-earned ratio: EBIT/interest expense. A measure of a firm’s ability to meet interest payments.



Other measures of ability to meet interest payments. o EBITDA coverage ratio: (EBITDA+ lease payments)/(interest + principal payments + lease payments). o Fixed payments coverage ratio: (EBIT + lease payments)/((interest + lease payments + (principal payments + preferred stock dividends)*(1-T)).

Profitability Ratios 

Profitability ratios help analyze the profitability of a firm.



Profit margin: (sales – COGS)/sales



Operating profit margin: EBIT/sales



Net profit margin (NPM): Net income/sales



Earnings per share: Net income/# of shares outstanding



Basic earning power: EBIT/total assets



Return on equity (ROE): Net income/equity. An important ratio which tells investors their rate of return.



Return on assets (ROA): Net income/assets.

Market Value Ratios 

Price/earnings ratio: Market price per share/earnings per share.



Price/cash flow ratio: Market price per share/cash flow per share.



Market/book ratio: Market price per share/Book value per share.

Key Takeaways

© 2019 FlatWorld



Ratio analysis helps analyze the financial strength of a company.



The main categories of ratio analysis are liquidity, debt management, asset management, profitability, and market value.

Key Terms                    

Ratio analysis: A quantitative tool used to analyze a company’s financial statements.

Liquidity ratios: Ratios that measure the ability of a company to meet its short-term financial obligations.

Current ratio: Current assets divided by current liabilities.

Quick ratio: Current assets less inventories divided by current liabilities.

Asset management ratios: Ratios used to measure the effectiveness of a firm in managing its assets.

Inventory turnover ratio: How many times during a year a firm’s inventory is bought and sold. Defined as the cost of goods sold divided by the average inventory.

Average age of inventory: Defined as 365 divided by the inventory turnover ratio.

Average payment period: Measures how long it takes a company to pay its suppliers.

Defined as accounts payable divided by average purchases per day.

Receivables turnover ratio: Measures how effective a company is in collecting money owed to them. Defined as sales divided by accounts receivable.

Total asset turnover ratio (TAT): A measure of how effective a firm is in using its assets to generate sales. Defined as sales divided by total assets.

Fixed asset turnover: A measure of how effective a firm is in using its fixed assets to generate sales. Defined as sales divided by total assets.

Debt management ratios: Calculate how much a firm uses debt as a source of funding.

Debt ratio: The ratio of debt to assets. Defined as total liabilities divided by total assets.

Debt-equity ratio: The ratio of dollars of debt for every dollar of equity. Calculated by total liabilities divided by the difference between total assets and total liabilities.

Equity multiplier (EM): Total assets divided by total equity; it is directly related to the debt-equity ratio, and represents the leverage of the firm, that is, how many dollars of assets each dollar of equity supports.

Times-interest-earned (TIE): A measure of the firm’s ability to pay interest. Is EBIT divided by interest expense.

EBITDA coverage ratio: Improves upon TIE by including other variables such as lease payments. It is calculated by the sum of EBITDA and lease payments divided by the sum of interest plus principal payments plus lease payments.

Fixed-payments coverage ratio: A measure of the firm’s ability to pay back fixed debts.

Profitability ratios: Analyze the profitability of a firm.

Profit margin: The amount of profit left over after all direct expenses are paid. Defined by the difference between sales and cost of goods sold divided by sales. © 2019 FlatWorld

          

Operating profit margin: Profit margin using only operating expenses. Defined as operating profits divided by sales.

Net profit margin (NPM): Net income divided by sales, or the percentage of each sales dollar that remains after all expenses have been deducted including interest and taxes.

Earnings per share (EPS): The amount of earnings generated by each share of stock. It is earnings available for common stockholders divided by number of shares of common stock outstanding.

Basic earning power (BEP): The raw earning power of the firm before taxes and leverage. It is EBIT divided by total assets.

Return on equity (ROE): The return investors are earning on their investment. Defined as net income divided by common equity.

Return on assets (ROA): The return managers are earning on assets. Defined by net income divided by total assets.

Market value ratios: These ratios relate a firm’s value (measure by stock price) with other variables.

Price/earnings ratio: Shows how much investors are willing to pay per dollar of profit.

Calculated by dividing the price per share by the earnings per share of stock.

Price/cash flow ratio: Measures the ability of the company to generate cash. Defined as the price per share divided by the cash flow per share.

Market/book ratio: Measures the market value of the firm to the book value. Defined as market value per share of stock divided by the book value per share of stock.

Book value per share: Is the common stock equity divided by the number of shares of stock outstanding.

Answers to Exercises 1. Answers will vary based on the current 10-K.

Section 8. DuPont Analysis and Comparisons  

The DuPont equation combines ROE and ROA. Comments and limitations on ratio analysis.

Section Outline DuPont Analysis and Comparisons 

The DuPont equation is a useful way of examining ROE. © 2019 FlatWorld



ROE=Net profit margin * Total asset turnover * Equity multiplier

Comparative Analysis 

In order to make sense of ratios, they should be compared to competitors and to a firm’s trend over time.



A single ratio is not sufficient to analyze a firm.



Beware of seasonal effects.



Beware of different accounting treatments.



Common size balance sheets and income statements help account for firms of differing sizes.

Key Takeaways 

Ratio analysis is an important and fun tool to analyze the financial health of a company.

Understanding what the ratios tell us and putting the ratios into context are important factors in correct use of the formula.



The DuPont equation breaks down ROE into key drivers to analyze a company.

Key Terms 

DuPont analysis: A very useful way to analyze a company’s financial position by breaking down ROE into its key drivers.

Answers to Exercises

1. Answers will vary based on the current 10-K.

Section 9. Worked Problems: Niks2 Inc.  

See ratio analysis in work!

Calculate and analyze ratios for a fictional company.

© 2019 FlatWorld

Section Outline Work through the example, putting ratio analysis to work.

Key Takeaways 

Ratio analysis is easy and fun! It’s just a matter of knowing what number to put where.

Practice makes perfect!



Comparing ratios over time and against competitors is an interesting way to analyze a company. It is as much of an art than it is a science.

Answers to Exercises 1. a. b. c. d.

NPM*TAT*EM=0.10*1.65*23717/9040=0.095*1.65*2.62=0.41 21643/5622=3.85 times 365/3.85 = 94.8 days (Assuming annual purchases are 50% of COGS) Avg. Purchases per day = .5*21643/365=29.65; Average Payment Period=2612/29.65=88.09 days e. 3731/39117=0.10 2. Answers will vary based on the current 10-K. Depending upon the ratios, they may not agree. Some of the yahoo ratios are based on slightly different calculations, and some will use the latest quarterly numbers which could be different than the 10-K.

Section 10. The Bigger Picture  

Describe how financial statements relate to financial management.

Explain ethical considerations of financial statements.

Section Outline © 2019 FlatWorld

Ethical Considerations 

Financial statements can be adjusted (legally) to paint the company in a better light.



Managers should balance the duty to disclose with the framing of the numbers.

Key Takeaways 

Just as looking under the hood gives a good idea of how a car runs, examining financial statements allows us to better understand how the firm raises capital, creates value, and returns that value to investors.



Managers have an ethical responsibility to make sure that statements are not just legal, but also not intentionally misleading.

Answers to Exercises 1. a. Current Ratio; quick ratio; inventory turnover; average age of inventory. Those are the most directly affected, but anything with assets could also be affected. b. Does the way we account for inventory accurately reflect the value? Is the accounting method legal? What should we do to disclose the change?

2. The law certainly changed, so we need to properly account for that (for example, with taxes, esp. with repatriating), but we should still follow our ethical system.

3. Not necessarily. Regulations can sometimes distort what the statement shows, since companies will have to follow the “rule” instead of having the freedom to try to accurately represent the data. But with less regulation, there can be more room for unethical behavior. It is a trade-off.

Section 11. End-of-Chapter Exercises Answers to Exercises 1. Numbers will vary based upon company chosen.

2. a. $15 million * .60 = $9 million b. $15 million - $9 million = $6 million c. $15 million * .30 = $4.5 million © 2019 FlatWorld

d. e. f. g.

$9 million - $4.5 million = $4.5 million $15 million * .04 = $0.6 million $15 million / x = 1.5 times; solve for x. $15 million / 1.5 = $10 million $0.6 million/$10 million = 0.06 = 6%

3.

Assuming that all salary, benefits, and employment taxes are part of COGS, since all the employees work directly on landscaping. Assuming that the trucks are a 12 month lease.

Revenues $ 310,000 COGS $ 215,120 Gross Profits $ 94,880 SG&A $ 58,100 Depreciation $ 9,200 Total Operating Expenses $ 67,300 Operating Profit (EBIT) $ 27,580 Interest $ 5,000 Net profit before taxes (EBT) $ 22,580 Taxes $ 4,742 Net income $ 17,838 b.

Answers vary based upon ratios used. Some examples: Net profit margin=5.75%; Operating profit margin=8.90%.

1.

© 2019 FlatWorld

Chapter 4 Pro Forma Statements Predicting the Future?? 

Companies use “pro forma” statements to help a company plan for the future.



Pro forma statements are predictions of future financial statements.

Section 1. Pro Forma Income Statement 

Analyze a pro forma income statement and its purpose.



Complete a pro forma income statement.

Section Outline 

A pro forma income statement is a projected income statement. o The simplest method is the percent-of-sales method, where expenses are expressed as a percentage of sales. o A common size income statement is created using a percentage of sales of sales.

Key Takeaways 

Pro forma statements are a way to look into the future. The pro forma income statement projects future cash flow. o The pro forma income statement uses current sales to calculate future sales. o Many expenses are increased using the percent-of-sales method. Some expenses will remain the same. © 2019 FlatWorld

Key Terms   

Pro forma income statement: A projected income statement.

Percent-of-sales method: Future sales are forecasted, and then expenses are calculated as a percentage of the new sales figure.

Common size income statement: A income statement with all entries expressed as a percentage of revenues.

Answers to Exercises 1. A projected income statement, or one that shows a hypothetical scenario. They are used to help model expectations either in the future or in a hypothetical situation, such as a new product launch.

2.

Revenues COGS Gross Profits SG&A Depreciation Total Operating Expenses Operating Profit (EBIT) Interest Net profit before taxes (EBT) Taxes Net income

100% 43% 57% 22% 10% 32% 25% 5% 20% 8% 12%

3.

Revenues COGS Gross Profits SG&A Depreciation Total Operating Expenses Operating Profit (EBIT) Interest Net profit before taxes (EBT)

$ $ $ $ $ $ $ $

105,000 45,150 59,850 23,100 10,500 33,600 26,250 5,000

$

21,250 © 2019 FlatWorld

Taxes Net income

$ $

8,500 12,750

Section 2. Pro Forma Balance Sheet 

Analyze a Pro Forma Balance Sheet and its purpose.



Complete a Pro Forma Balance Sheet.

Section Outline 

Similar to a pro forma income statement, a pro forma balance sheet is a projection of the balance sheet.



A common size balance sheet can be used.

Key Takeaways 

Pro Forma balance sheets provide a look into a company’s future. o They can be constructed using percentage changes from the previous year. o It is more accurate to use last year’s balance sheet and past information to make realistic assumptions about the next year.

Key Terms  

Pro forma balance sheet: A projected balance sheet.

Common size balance sheet: A balance sheet with entries expressed as a percentage of total assets.

Answers to Exercises © 2019 FlatWorld

1. First Pass (in thousands): Assets Cash accounts receivable Inventories Total C.A. Land and buildings Machinery and equipment Total F.A.

Total Assets

$ $ $ $ $ $ 9.0 $

$

30.0 18.9 10.0 58.9 17.6

26.6

85.5

Liabilities and Equity Accounts Payable Notes Payable Total C.L. Long-term debt Total Liabilities Common Stock Retained Earnings Total Equity Total Liabilities and Equity

$ $ $

$ $

15.8 21.0 $ 10.0 $ 17.1 16.5 $

36.8 46.8

33.6

$

80.4

$ $

15.8 21.0 $ 36.8 15.1 $ 51.9

Second pass, using Long-term debt to balance (in thousands): Assets Cash accounts receivable Inventories Total C.A. Land and buildings

30.0 18.9 10.0 58.9 17.6

Machinery and equipment Total F.A.

$ $ $ $ $ $ 9.0 $

Total Assets

$

85.5

26.6

Liabilities and Equity Accounts Payable Notes Payable Total C.L. Long-term debt Total Liabilities Common Stock Retained Earnings Total Equity Total Liabilities and Equity

$

$ $

17.1 16.5 $ 33.6

$

85.5

Section 3. Assessment of Pro Forma Statements 

Use pro forma statements to analyze a business.

Section Outline 

Pro forma statements can be used to create best, worst, and most likely case scenarios.



Assumptions are key to the pro forma statements. © 2019 FlatWorld

Key Takeaways 

Understand the assumptions behind the pro forma statements.



Analyze the financial statements, taking risk into account, and look at a best, worst, and most likely case scenarios.

Answers to Exercises 1. Since pro-forma statements in this context are dealing with unknown future results, they can be useful tools in modeling outcomes that are possible but not necessarily the expected.

2. Assuming no interest and all scales with sales: Sales COGS Gross Profit SG&A Depreciation Operating Profit Interest EBT Tax Net Income

Base $ 100,000 $ 43,000 $ 57,000 $ 22,000 $ 10,000

Best Worst $ 120,000 $ 95,000 $ 51,600 $ 40,850 $ 68,400 $ 54,150 $ 26,400 $ 20,900 $ 12,000 $ 9,500

$ $ $ $ $

$ $ $ $ $

25,000 25,000 5,250 19,750

30,000 30,000 6,300 23,700

$ $ $ $ $

23,750 23,750 4,988 18,763

3. Assuming no interest and all scales with sales: Sales COGS Gross Profit SG&A Depreciation Operating Profit

Base $ 3,500,000 $ 1,950,000 $ 1,550,000 $ 750,000 $ 350,000

Best $ 4,025,000 $ 2,242,500 $ 1,782,500 $ 862,500 $ 402,500

Worst $ 3,570,000 $ 1,989,000 $ 1,581,000 $ 765,000 $ 357,000

$

$

$

450,000

517,500

© 2019 FlatWorld

459,000

Interest EBT Tax Net Income

$ $ $ $

450,000 94,500 355,500

$ $ $ $

517,500 108,675 408,825

$ $ $ $

459,000 96,390 362,610

Section 4. The Bigger Picture  

Discuss the role pro forma statements play in financial management.

Identify the ethical considerations involved when creating pro forma statements.

Section Outline 

Correct calculation and analysis is important in the planning for the future.



Managers may have ulterior motives to alter projections for personal benefit.

Key Takeaways 

Pro forma statements assist managers in making many business decisions.



Ethics play an important role in the correct creation of pro forma statements.

Section 5. End-of-Chapter Exercises Answers to Exercises 1. Pro forma sheets help companies plan for the future or for different scenarios. Pro forma sheets can help model different situations, but they are only as good as the assumptions made. Pro forma statements do not necessarily have to comply with GAAP. 2. Assuming no depreciation: Sales COGS

$ 5,500,000 $ 4,000,000

© 2019 FlatWorld

Gross Profit SG&A Depreciation Operating Profit Interest EBT Tax Net Income

$ 1,500,000 $ 700,000 $ $ $ $ $ $

800,000 50,000 750,000 300,000 450,000

3. Assuming the tax _rate_ remains the same: Sales COGS Gross Profit SG&A Depreciation Operating Profit Interest EBT Tax Net Income

$ 5,775,000 $ 4,120,000 $ 1,655,000 $ 749,000 $ $ 906,000 $ 50,000 $ 856,000 $ 342,400 $ 513,600

4. Assuming that all unmentioned accounts have zero balance, except retained earnings must be the amount that makes the sheet balance (in thousands).

Assets Cash accounts receivable Inventories Total C.A. Land and buildings Machinery and equipment Total F.A. Total Assets

$

5.

Assets Cash accounts receivable Inventories Total C.A. Land and buildings Machinery and equipment

$ $ $ $ $ $ $

20.0 18.0 22.0 60.0 39.0 39.0 99.0

Liabilities and Equity Accounts Payable Notes Payable Total C.L. Long-term debt Total Liabilities Common Stock Retained Earnings Total Equity Total Liabilities and Equity

$ $ $ $ $ $ $ $ $

40.0 35.0 75.0 15.0 90.0 9.0 9.0 99.0

Liabilities and Equity 20.2% Accounts Payable 18.2% Notes Payable 22.2% Total C.L.

40.4% 35.4% 75.8%

60.6% Long-term debt 0.0% Total Liabilities 39.4% Common Stock

15.2% 90.9% 0.0%

© 2019 FlatWorld

Total F.A.

39.4% Retained Earnings Total Equity 100.0% Total Liabilities and Equity

Total Assets

9.1% 9.1% 100.0%

6. "depreciation" should only be in the expenses once, for an EBIT of 301.6; EBT of 276.6; and Net income of 166.0 (in thousands)

Base Sales COGS Gross Profit SG&A Depreciation Operating Profit Interest EBT Tax Net Income

Worst

Most Likely

Best

$ $ $ $ $

1,680.0 910.4 769.6 389.0 79.0

$ $ $ $ $

1,764.0 955.9 808.1 408.5 79.0

$ $ $ $ $

1,848.0 1,001.4 846.6 427.9 79.0

$ $ $ $ $

1,932.0 1,047.0 885.0 447.4 79.0

$ $ $ $ $

301.6 25.0 276.6 110.6 166.0

$ $ $ $ $

320.6 25.0 295.6 118.3 177.4

$ $ $ $ $

339.7 25.0 314.7 125.9 188.8

$ $ $ $ $

358.7 25.0 333.7 133.5 200.2

7. Using the "most likely" scenario from Problem #6 and assuming no dividends, accounts receivable will scale with sales, and with excess funding going into “cash”, the first pass (in thousands): Assets Liabilities and Equity Cash $ 100.0 Accounts Payable $ 123.0 Short-term Short-term investments $ 28.6 Accruals investments accounts receivable $ 178.8 Notes Payable $ 21.0 Inventories $ 25.0 Total C.L. Inventories Total C.A. $ 332.4 Long-term debt $ 82.6 Total Land and Land and buildings $ 103.2 Liabilities buildings Machinery and equipment $ 62.4 Common Stock $ 151.1 Gross F.A. $ 165.6 Retained Earnings $ 253.8 Less: Less: Depreciation $ (102.1) Total Equity Depreciation Net F.A. $ 63.50 Total Liabilities and Total Assets $ 395.9 Equity $ 645.0 To balance, put the extra 249.1 into cash: © 2019 FlatWorld

Assets Cash Short-term investments accounts receivable Inventories Total C.A. Land and buildings Machinery and equipment Gross F.A. Less: Depreciation Net F.A. Total Assets

$ $ $ $ $ $ $ $ $ $ $

© 2019 FlatWorld

349.1 28.6 178.8 25.0 581.5 103.2 62.4 165.6 (102.1) 63.50 645.0

Liabilities and Equity Accounts Payable Accruals Notes Payable Total C.L. Long-term debt Total Liabilities Common Stock Retained Earnings Total Equity Total Liabilities and Equity

Chapter 5 Time Value of Money: One Cash Flow A Dollar Today vs. A Dollar Tomorrow 

What is better? Cash now or later???

Section 1. Present Value and Future Value 

Define and explain investments and opportunity cost.



Define and explain the concepts of present value and future value.

Section Outline 

Investments are evaluated against the opportunity cost of not taking the investment.



Cash flows occurring at different times must account for this difference in time. o The present value of a cash flow is the equivalent value today. o The future value of a cash flow is the value of the cash flow in the future.

Key Takeaways 

Everyone’s resources are limited, so committing to an investment has an opportunity cost equal to the best alternative use of the resources.



Comparing PVs with FVs tells us nothing. Comparisons can only be made with cash flows evaluated at the same point in time.



A dollar (euro, yen, etc.) today is worth more than a dollar tomorrow.

© 2019 FlatWorld

Key Terms    

Investment: A choice to commit limited resources faced with a set potential outcomes.

Opportunity cost: The greatest outcome from the set of choices not taken when considering an investment.

Present value (PV): The equivalent value of an outcome in today’s cash.

Future value (FV): A cash flow at any time later than the present.

Answers to Exercises 1. Present value will always be greater than or equal to future value.

2. In general: loss of income from working a full-time job, or not seeing your family for the semester (if you don’t live close to home). One class: maybe just lost sleep, but maybe a shift at a part-time job.

Section 2. Principal and Interest 

Define the concepts of principal and interest.



Describe how an interest rate is derived from a PV and FV.



Describe how a market interest rate is determined.

Section Outline 

The future value of a cash flow is equal to the principal plus the interest.



In order to compare two cash flows occurring at different times, one must adjust the flows by the amount of interest.

Key Takeaways © 2019 FlatWorld



Principal + Interest = FV



Interest is derived from the difference between PV and FV and is compensation for the costs (including opportunity costs and the cost of perceived risk) of an investment.



The market interest rate is derived from the relative values of PV and FV by the participants.

Key Terms   

Principal: In a loan, the amount originally borrowed.

Interest: In a loan, the difference between the amount borrowed and the amount repaid.

Interest rate: The ratio of the interest to the principal for a loan. Typically expressed as an APR.

Answers to Exercises 1. 10% 2. $10; FV=$210 3. $400

Section 3. Simple Interest  

Define simple interest.

Calculate simple interest for an investment.

Section Outline 

The simple interest is the interest using ONLY the outstanding principle.

Key Takeaways © 2019 FlatWorld



Simple Interest: PV * (1 + nr) = FV

Answers to Exercises 1.

2.

3.

4.

$48; FV=$348 $1,000 per week interest, so $1,000/$5,000=20% $720/(1+4*5%)=$600 $848

Section 4. Compound Interest  

Define compound interest.

Calculate compound interest for an investment.

Section Outline 

Compound interest includes interest earned on both the principal and accrued interest.



The equation, PV * (1+r)n = FV can be manipulated to solve for any of the four inputs, given the other three.

Key Takeaways 

PV*(1+r)n = FV



Compound interest includes interest-on-interest.

Key Terms

© 2019 FlatWorld

 

Compound interest: Determining interest in each period based upon principal and accrued interest.

Compounding period: How frequently interest-on-interest is determined.

Answers to Exercises 1. $50.96; $2.96 more with compounding; FV=$350.96 2. $848; $898.88; $952.81 3. $300/1.06= $283.02

Section 5. Solving Compound Interest Problems     

Create timelines to solve single cash flow problems.

Calculate the FV of a cash flow.

Calculate the PV of a cash flow.

Calculate the interest rate implied by two cash flows.

Use a calculator or spreadsheet to calculate FV, PV, r, or n, given the other 3 inputs.

Section Outline 

Using a timeline is helpful to solve cash flow problems.



A sanity check for our work is to compare our answer to one using simple interest.



When solving problems, keep the interest rate to four digits before rounding.



Solve for PV, FV, r, and number of periods, given the other three inputs. Financial calculators and spreadsheets can be used to solve these problems.



The Rule of 72 is an easy way to find the time it takes to double an investment.

Approximately the time it takes to double is equal to 72/r.

Key Takeaways 

Always make a timeline. PV is to the left of FV. © 2019 FlatWorld



When using a financial calculator or a spreadsheet function, cash inflows are positive and outflows are negative. There must always be at least one of each type if solving for r or n.

Answers to Exercises 1. Annually: $144.07; Monthly: $147.25; Daily: $147.54 2. 16.961%; APR=881.97% 3. Annually=$6,088.00; Monthly=$6,061.14

Section 6. Effective Interest Rates  

Explain the difference between an APR and an effective interest rate.

Calculate an effective interest rate.

Section Outline 

The effective interest rate is the equivalent rate if it were compounded annually.



Most financial calculators include a function which computes the effective interest rate.

Key Takeaway 

Comparing rates using APRs could be misleading; calculating the effective interest rate allows for direct comparison.

Answers to Exercises 1. 20.92%

© 2019 FlatWorld

Section 7. End-of-Chapter Exercises

Answers to Exercises

1. a. $283.71 b. $275.22 2. FV for 15% compounded daily=$1,568.17; FV for 16% annually=$1,560.90; 15% compounded daily is better.

3. a. 30.08 years b. 10.50% 4. a. $7,090.18 b. $9,010.69 5. PV=$685.87, so $800 in two years. At 9%, the PV drops to $673.34, so $680 today would then be preferable.

6. Compounding monthly, if they have the same advertised APR, as it will have a higher effective rate.

7. a. b. c. d. e. f. g. h.

$1.32 $1.33 $1.22 $3.99 $4.21 $12.16 € 17.49 € 174,900.63

8. a. Estimate:72/12=6 years; 6.12 years actual b. Estimate:72/6=12 years; 11.90 years actual c. Estimate:72/1=72 quarters; 69.66 quarters actual d. Estimate: 72/.7=103 days; 99.37 days actual 9. The FV of the bond (assuming the bond compounds the interest!) is $1,169.86, so the opportunity cost (the interest lost), would be $169.86. If the bond pays an annual coupon (simple interest, if the cash isn’t reinvested), then the opportunity cost (interest lost) is $160.00. © 2019 FlatWorld

10. If Bill doesn’t invest the money, then the opportunity cost would be $22,000*4 = $88,000. But if we assume Bill would have been paid at the end of each year, and he invests it at 3% until 2024, then the FV of each year, respectively, is $24,039.99;$23,339.80;$22,660.00; and $22,000.00. The sum of these 4 values is $92,039.79

© 2019 FlatWorld

Chapter 6 Time Value of Money: Multiple Cash Flows The Cash Comes In, The Cash Goes Out 

How do know if we are paying the proper amount of our mortgage, credit card, or student loan bill?



What is the effect of paying $5 more than the minimum?

Section 1. Multiple Cash Flows 

Calculate the NPV of an investment.



Evaluate investment choices using NPV.

Section Outline 

The net present value is found by discounting all cash flows back to the present.



Financial calculators and spreadsheets have functions to calculate the NPV.

Key Takeaways 

The net present value (NPV) of an investment can be found by summing the PVs of all of its cash flows.



Comparing investments is most easily done by comparing their NPVs: the higher the NPV, the better the investment.

© 2019 FlatWorld

Key Terms 

net present value (NPV): Discounting all of the cash flows for an investment to the present, adding inflows and subtracting outflows.

Answers to Exercises 1. $227.65 2. 8%: NPVa=($87.13); NPVb=$18.52; Investment B is better; 5%: NPVa=$76.54; NPVb=$47.62; Investment A is better.

Section 2. Perpetuities 

Define a perpetuity.



Calculate the PV of a perpetuity.



Explain how the PV of a perpetuity is derived.

Section Outline 

A perpetuity is a series of constant payments lasting forever.



The present value of a perpetuity can be found by dividing the payment by the rate of interest: PMT/r.



A perpetuity where the payments grow at a constant rate is called a constant growth perpetuity.



The present value of a perpetuity is equal to the next payment divided by (r-g): PMTn+1/(r-g).

Key Takeaways

© 2019 FlatWorld



A perpetuity is a constant stream of payments lasting forever, but a finite PV can be calculated.



The perpetuity equation can be extended to account for cases where the payment grows over time, provided that the rate of growth is less than the interest rate.

Key Terms 

Perpetuity: Constant periodic payments lasting forever.

Answers to Exercises 1. $50/.1=$500; $50/(.1-.02)=$625 2. It will still be worth $200, if interest rates didn’t change. If interest rates go up, the perpetuity will fall in value.

Section 3. Annuities  

For an annuity, calculate the fifth variable given four of: PV, FV, rate, PMT, and n.

Calculate the PV of an annuity due.

Section Outline 

An annuity is a series of constant payments over a fixed period.



Financial calculators and spreadsheets can solve for one of the five variables of an annuity, given the other four.



Annuity payments are assumed to occur at the end of the period. When payments occur at the beginning, it is called an annuity due.

Key Takeaways © 2019 FlatWorld



Annuities are a fixed stream of payments over a finite time. Given four of PV, FV, rate, PMT, and n, the fifth variable can be solved for.



Rate, PMT, and n should all be in the same time units!



An annuity due is a type of annuity where the payments are due at the beginning of the period.

Key Terms 

Annuity: Constant periodic payments over a fixed amount of time.

Answers to Exercises 1. $94,946.55; annuity due=$95,896.02

Section 4. Loan Amortization  

Explain loan amortization.

Create an amortization schedule.

Section Outline 

An amortization schedule can be created by subtracting the amount of the payment which can be applied to the principal of the loan.



The amortization schedule can be used to analyze the paying down of principal.

© 2019 FlatWorld

Key Takeaways 

Payments can be broken into principal and interest components.



As principal is paid down, interest decreases. Future payments will, over time, accelerate in their rate of paying down principal.



Negative amortization can actually increase principal balances over time.

Key Terms 

Amortization: The process of spreading out the principal payments of a loan over time.

Answers to Exercises 1. 76 months 2. PMT=$1,199,10

month beg. Balance 1 $200,000.00 2 $199,800.90 3 $199,600.80 4 $199,399.71 5 $199,197.60 6 $198,994.49 7 $198,790.36 8 $198,585.21 9 $198,379.04 10 $198,171.83 11 $197,963.59 12 $197,754.31 13 $197,543.98 14 $197,332.60 15 $197,120.16 16 $196,906.66 17 $196,692.09 18 $196,476.45 19 $196,259.73 20 $196,041.93 21 $195,823.04

pmt interest principal $1,199.10 $1,000.00 $199.10 $1,199.10 $999.00 $200.10 $1,199.10 $998.00 $201.10 $1,199.10 $997.00 $202.10 $1,199.10 $995.99 $203.11 $1,199.10 $994.97 $204.13 $1,199.10 $993.95 $205.15 $1,199.10 $992.93 $206.17 $1,199.10 $991.90 $207.21 $1,199.10 $990.86 $208.24 $1,199.10 $989.82 $209.28 $1,199.10 $988.77 $210.33 $1,199.10 $987.72 $211.38 $1,199.10 $986.66 $212.44 $1,199.10 $985.60 $213.50 $1,199.10 $984.53 $214.57 $1,199.10 $983.46 $215.64 $1,199.10 $982.38 $216.72 $1,199.10 $981.30 $217.80 $1,199.10 $980.21 $218.89 $1,199.10 $979.12 $219.99 © 2019 FlatWorld

end balance $199,800.90 $199,600.80 $199,399.71 $199,197.60 $198,994.49 $198,790.36 $198,585.21 $198,379.04 $198,171.83 $197,963.59 $197,754.31 $197,543.98 $197,332.60 $197,120.16 $196,906.66 $196,692.09 $196,476.45 $196,259.73 $196,041.93 $195,823.04 $195,603.05

22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64

$195,603.05 $195,381.96 $195,159.77 $194,936.47 $194,712.05 $194,486.51 $194,259.84 $194,032.04 $193,803.10 $193,573.01 $193,341.78 $193,109.39 $192,875.83 $192,641.11 $192,405.22 $192,168.14 $191,929.88 $191,690.43 $191,449.78 $191,207.93 $190,964.87 $190,720.59 $190,475.09 $190,228.37 $189,980.41 $189,731.21 $189,480.76 $189,229.06 $188,976.11 $188,721.89 $188,466.40 $188,209.63 $187,951.57 $187,692.23 $187,431.59 $187,169.65 $186,906.40 $186,641.83 $186,375.94 $186,108.71 $185,840.16 $185,570.26 $185,299.01

$1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10

$978.02 $976.91 $975.80 $974.68 $973.56 $972.43 $971.30 $970.16 $969.02 $967.87 $966.71 $965.55 $964.38 $963.21 $962.03 $960.84 $959.65 $958.45 $957.25 $956.04 $954.82 $953.60 $952.38 $951.14 $949.90 $948.66 $947.40 $946.15 $944.88 $943.61 $942.33 $941.05 $939.76 $938.46 $937.16 $935.85 $934.53 $933.21 $931.88 $930.54 $929.20 $927.85 $926.50

$221.09 $222.19 $223.30 $224.42 $225.54 $226.67 $227.80 $228.94 $230.09 $231.24 $232.39 $233.55 $234.72 $235.90 $237.07 $238.26 $239.45 $240.65 $241.85 $243.06 $244.28 $245.50 $246.73 $247.96 $249.20 $250.45 $251.70 $252.96 $254.22 $255.49 $256.77 $258.05 $259.34 $260.64 $261.94 $263.25 $264.57 $265.89 $267.22 $268.56 $269.90 $271.25 $272.61

© 2019 FlatWorld

$195,381.96 $195,159.77 $194,936.47 $194,712.05 $194,486.51 $194,259.84 $194,032.04 $193,803.10 $193,573.01 $193,341.78 $193,109.39 $192,875.83 $192,641.11 $192,405.22 $192,168.14 $191,929.88 $191,690.43 $191,449.78 $191,207.93 $190,964.87 $190,720.59 $190,475.09 $190,228.37 $189,980.41 $189,731.21 $189,480.76 $189,229.06 $188,976.11 $188,721.89 $188,466.40 $188,209.63 $187,951.57 $187,692.23 $187,431.59 $187,169.65 $186,906.40 $186,641.83 $186,375.94 $186,108.71 $185,840.16 $185,570.26 $185,299.01 $185,026.40

65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107

$185,026.40 $184,752.43 $184,477.09 $184,200.38 $183,922.28 $183,642.79 $183,361.90 $183,079.61 $182,795.91 $182,510.78 $182,224.24 $181,936.26 $181,646.84 $181,355.97 $181,063.65 $180,769.87 $180,474.62 $180,177.89 $179,879.68 $179,579.97 $179,278.77 $178,976.06 $178,671.84 $178,366.10 $178,058.83 $177,750.02 $177,439.67 $177,127.77 $176,814.31 $176,499.28 $176,182.67 $175,864.49 $175,544.71 $175,223.33 $174,900.35 $174,575.75 $174,249.52 $173,921.67 $173,592.18 $173,261.04 $172,928.24 $172,593.78 $172,257.65

$1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10

$925.13 $923.76 $922.39 $921.00 $919.61 $918.21 $916.81 $915.40 $913.98 $912.55 $911.12 $909.68 $908.23 $906.78 $905.32 $903.85 $902.37 $900.89 $899.40 $897.90 $896.39 $894.88 $893.36 $891.83 $890.29 $888.75 $887.20 $885.64 $884.07 $882.50 $880.91 $879.32 $877.72 $876.12 $874.50 $872.88 $871.25 $869.61 $867.96 $866.31 $864.64 $862.97 $861.29

$273.97 $275.34 $276.72 $278.10 $279.49 $280.89 $282.29 $283.70 $285.12 $286.55 $287.98 $289.42 $290.87 $292.32 $293.78 $295.25 $296.73 $298.21 $299.70 $301.20 $302.71 $304.22 $305.74 $307.27 $308.81 $310.35 $311.90 $313.46 $315.03 $316.60 $318.19 $319.78 $321.38 $322.98 $324.60 $326.22 $327.85 $329.49 $331.14 $332.80 $334.46 $336.13 $337.81

© 2019 FlatWorld

$184,752.43 $184,477.09 $184,200.38 $183,922.28 $183,642.79 $183,361.90 $183,079.61 $182,795.91 $182,510.78 $182,224.24 $181,936.26 $181,646.84 $181,355.97 $181,063.65 $180,769.87 $180,474.62 $180,177.89 $179,879.68 $179,579.97 $179,278.77 $178,976.06 $178,671.84 $178,366.10 $178,058.83 $177,750.02 $177,439.67 $177,127.77 $176,814.31 $176,499.28 $176,182.67 $175,864.49 $175,544.71 $175,223.33 $174,900.35 $174,575.75 $174,249.52 $173,921.67 $173,592.18 $173,261.04 $172,928.24 $172,593.78 $172,257.65 $171,919.84

108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150

$171,919.84 $171,580.34 $171,239.14 $170,896.23 $170,551.61 $170,205.27 $169,857.19 $169,507.38 $169,155.81 $168,802.49 $168,447.40 $168,090.54 $167,731.89 $167,371.45 $167,009.21 $166,645.15 $166,279.28 $165,911.57 $165,542.03 $165,170.64 $164,797.39 $164,422.28 $164,045.29 $163,666.41 $163,285.64 $162,902.97 $162,518.38 $162,131.87 $161,743.43 $161,353.05 $160,960.71 $160,566.41 $160,170.15 $159,771.90 $159,371.65 $158,969.41 $158,565.16 $158,158.88 $157,750.58 $157,340.23 $156,927.83 $156,513.37 $156,096.83

$1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10

$859.60 $857.90 $856.20 $854.48 $852.76 $851.03 $849.29 $847.54 $845.78 $844.01 $842.24 $840.45 $838.66 $836.86 $835.05 $833.23 $831.40 $829.56 $827.71 $825.85 $823.99 $822.11 $820.23 $818.33 $816.43 $814.51 $812.59 $810.66 $808.72 $806.77 $804.80 $802.83 $800.85 $798.86 $796.86 $794.85 $792.83 $790.79 $788.75 $786.70 $784.64 $782.57 $780.48

$339.50 $341.20 $342.91 $344.62 $346.34 $348.07 $349.82 $351.56 $353.32 $355.09 $356.86 $358.65 $360.44 $362.24 $364.06 $365.88 $367.70 $369.54 $371.39 $373.25 $375.11 $376.99 $378.87 $380.77 $382.67 $384.59 $386.51 $388.44 $390.38 $392.34 $394.30 $396.27 $398.25 $400.24 $402.24 $404.25 $406.28 $408.31 $410.35 $412.40 $414.46 $416.53 $418.62

© 2019 FlatWorld

$171,580.34 $171,239.14 $170,896.23 $170,551.61 $170,205.27 $169,857.19 $169,507.38 $169,155.81 $168,802.49 $168,447.40 $168,090.54 $167,731.89 $167,371.45 $167,009.21 $166,645.15 $166,279.28 $165,911.57 $165,542.03 $165,170.64 $164,797.39 $164,422.28 $164,045.29 $163,666.41 $163,285.64 $162,902.97 $162,518.38 $162,131.87 $161,743.43 $161,353.05 $160,960.71 $160,566.41 $160,170.15 $159,771.90 $159,371.65 $158,969.41 $158,565.16 $158,158.88 $157,750.58 $157,340.23 $156,927.83 $156,513.37 $156,096.83 $155,678.21

151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192 193

$155,678.21 $155,257.50 $154,834.69 $154,409.76 $153,982.71 $153,553.52 $153,122.19 $152,688.70 $152,253.04 $151,815.21 $151,375.18 $150,932.96 $150,488.52 $150,041.86 $149,592.97 $149,141.83 $148,688.44 $148,232.78 $147,774.85 $147,314.62 $146,852.09 $146,387.25 $145,920.09 $145,450.58 $144,978.74 $144,504.53 $144,027.95 $143,548.99 $143,067.63 $142,583.87 $142,097.69 $141,609.08 $141,118.02 $140,624.51 $140,128.53 $139,630.07 $139,129.12 $138,625.67 $138,119.69 $137,611.19 $137,100.15 $136,586.55 $136,070.38

$1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10

$778.39 $776.29 $774.17 $772.05 $769.91 $767.77 $765.61 $763.44 $761.27 $759.08 $756.88 $754.66 $752.44 $750.21 $747.96 $745.71 $743.44 $741.16 $738.87 $736.57 $734.26 $731.94 $729.60 $727.25 $724.89 $722.52 $720.14 $717.74 $715.34 $712.92 $710.49 $708.05 $705.59 $703.12 $700.64 $698.15 $695.65 $693.13 $690.60 $688.06 $685.50 $682.93 $680.35

$420.71 $422.81 $424.93 $427.05 $429.19 $431.33 $433.49 $435.66 $437.84 $440.03 $442.23 $444.44 $446.66 $448.89 $451.14 $453.39 $455.66 $457.94 $460.23 $462.53 $464.84 $467.16 $469.50 $471.85 $474.21 $476.58 $478.96 $481.36 $483.76 $486.18 $488.61 $491.06 $493.51 $495.98 $498.46 $500.95 $503.46 $505.97 $508.50 $511.05 $513.60 $516.17 $518.75

© 2019 FlatWorld

$155,257.50 $154,834.69 $154,409.76 $153,982.71 $153,553.52 $153,122.19 $152,688.70 $152,253.04 $151,815.21 $151,375.18 $150,932.96 $150,488.52 $150,041.86 $149,592.97 $149,141.83 $148,688.44 $148,232.78 $147,774.85 $147,314.62 $146,852.09 $146,387.25 $145,920.09 $145,450.58 $144,978.74 $144,504.53 $144,027.95 $143,548.99 $143,067.63 $142,583.87 $142,097.69 $141,609.08 $141,118.02 $140,624.51 $140,128.53 $139,630.07 $139,129.12 $138,625.67 $138,119.69 $137,611.19 $137,100.15 $136,586.55 $136,070.38 $135,551.63

194 195 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220 221 222 223 224 225 226 227 228 229 230 231 232 233 234 235 236

$135,551.63 $135,030.29 $134,506.34 $133,979.77 $133,450.56 $132,918.72 $132,384.21 $131,847.03 $131,307.16 $130,764.60 $130,219.32 $129,671.31 $129,120.57 $128,567.07 $128,010.81 $127,451.76 $126,889.92 $126,325.27 $125,757.79 $125,187.48 $124,614.32 $124,038.29 $123,459.38 $122,877.57 $122,292.86 $121,705.22 $121,114.65 $120,521.12 $119,924.62 $119,325.15 $118,722.67 $118,117.18 $117,508.67 $116,897.11 $116,282.49 $115,664.81 $115,044.03 $114,420.15 $113,793.15 $113,163.01 $112,529.73 $111,893.27 $111,253.64

$1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10

$677.76 $675.15 $672.53 $669.90 $667.25 $664.59 $661.92 $659.24 $656.54 $653.82 $651.10 $648.36 $645.60 $642.84 $640.05 $637.26 $634.45 $631.63 $628.79 $625.94 $623.07 $620.19 $617.30 $614.39 $611.46 $608.53 $605.57 $602.61 $599.62 $596.63 $593.61 $590.59 $587.54 $584.49 $581.41 $578.32 $575.22 $572.10 $568.97 $565.82 $562.65 $559.47 $556.27

$521.34 $523.95 $526.57 $529.20 $531.85 $534.51 $537.18 $539.87 $542.57 $545.28 $548.00 $550.74 $553.50 $556.27 $559.05 $561.84 $564.65 $567.47 $570.31 $573.16 $576.03 $578.91 $581.80 $584.71 $587.64 $590.57 $593.53 $596.50 $599.48 $602.48 $605.49 $608.52 $611.56 $614.62 $617.69 $620.78 $623.88 $627.00 $630.14 $633.29 $636.45 $639.63 $642.83

© 2019 FlatWorld

$135,030.29 $134,506.34 $133,979.77 $133,450.56 $132,918.72 $132,384.21 $131,847.03 $131,307.16 $130,764.60 $130,219.32 $129,671.31 $129,120.57 $128,567.07 $128,010.81 $127,451.76 $126,889.92 $126,325.27 $125,757.79 $125,187.48 $124,614.32 $124,038.29 $123,459.38 $122,877.57 $122,292.86 $121,705.22 $121,114.65 $120,521.12 $119,924.62 $119,325.15 $118,722.67 $118,117.18 $117,508.67 $116,897.11 $116,282.49 $115,664.81 $115,044.03 $114,420.15 $113,793.15 $113,163.01 $112,529.73 $111,893.27 $111,253.64 $110,610.81

237 238 239 240 241 242 243 244 245 246 247 248 249 250 251 252 253 254 255 256 257 258 259 260 261 262 263 264 265 266 267 268 269 270 271 272 273 274 275 276 277 278 279

$110,610.81 $109,964.76 $109,315.48 $108,662.96 $108,007.17 $107,348.11 $106,685.75 $106,020.07 $105,351.07 $104,678.73 $104,003.02 $103,323.93 $102,641.45 $101,955.56 $101,266.24 $100,573.47 $99,877.23 $99,177.52 $98,474.30 $97,767.57 $97,057.31 $96,343.50 $95,626.11 $94,905.14 $94,180.57 $93,452.37 $92,720.53 $91,985.03 $91,245.86 $90,502.98 $89,756.40 $89,006.08 $88,252.01 $87,494.17 $86,732.54 $85,967.10 $85,197.83 $84,424.72 $83,647.74 $82,866.88 $82,082.12 $81,293.42 $80,500.79

$1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10

$553.05 $549.82 $546.58 $543.31 $540.04 $536.74 $533.43 $530.10 $526.76 $523.39 $520.02 $516.62 $513.21 $509.78 $506.33 $502.87 $499.39 $495.89 $492.37 $488.84 $485.29 $481.72 $478.13 $474.53 $470.90 $467.26 $463.60 $459.93 $456.23 $452.51 $448.78 $445.03 $441.26 $437.47 $433.66 $429.84 $425.99 $422.12 $418.24 $414.33 $410.41 $406.47 $402.50

$646.05 $649.28 $652.52 $655.79 $659.07 $662.36 $665.67 $669.00 $672.35 $675.71 $679.09 $682.48 $685.89 $689.32 $692.77 $696.23 $699.71 $703.21 $706.73 $710.26 $713.81 $717.38 $720.97 $724.58 $728.20 $731.84 $735.50 $739.18 $742.87 $746.59 $750.32 $754.07 $757.84 $761.63 $765.44 $769.27 $773.11 $776.98 $780.86 $784.77 $788.69 $792.63 $796.60

© 2019 FlatWorld

$109,964.76 $109,315.48 $108,662.96 $108,007.17 $107,348.11 $106,685.75 $106,020.07 $105,351.07 $104,678.73 $104,003.02 $103,323.93 $102,641.45 $101,955.56 $101,266.24 $100,573.47 $99,877.23 $99,177.52 $98,474.30 $97,767.57 $97,057.31 $96,343.50 $95,626.11 $94,905.14 $94,180.57 $93,452.37 $92,720.53 $91,985.03 $91,245.86 $90,502.98 $89,756.40 $89,006.08 $88,252.01 $87,494.17 $86,732.54 $85,967.10 $85,197.83 $84,424.72 $83,647.74 $82,866.88 $82,082.12 $81,293.42 $80,500.79 $79,704.19

280 281 282 283 284 285 286 287 288 289 290 291 292 293 294 295 296 297 298 299 300 301 302 303 304 305 306 307 308 309 310 311 312 313 314 315 316 317 318 319 320 321 322

$79,704.19 $78,903.61 $78,099.03 $77,290.42 $76,477.78 $75,661.06 $74,840.27 $74,015.37 $73,186.34 $72,353.17 $71,515.84 $70,674.32 $69,828.59 $68,978.63 $68,124.42 $67,265.94 $66,403.17 $65,536.09 $64,664.67 $63,788.89 $62,908.73 $62,024.17 $61,135.19 $60,241.77 $59,343.88 $58,441.50 $57,534.60 $56,623.17 $55,707.19 $54,786.62 $53,861.46 $52,931.66 $51,997.22 $51,058.10 $50,114.29 $49,165.76 $48,212.49 $47,254.45 $46,291.62 $45,323.98 $44,351.50 $43,374.16 $42,391.93

$1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10

$398.52 $394.52 $390.50 $386.45 $382.39 $378.31 $374.20 $370.08 $365.93 $361.77 $357.58 $353.37 $349.14 $344.89 $340.62 $336.33 $332.02 $327.68 $323.32 $318.94 $314.54 $310.12 $305.68 $301.21 $296.72 $292.21 $287.67 $283.12 $278.54 $273.93 $269.31 $264.66 $259.99 $255.29 $250.57 $245.83 $241.06 $236.27 $231.46 $226.62 $221.76 $216.87 $211.96

$800.58 $804.58 $808.61 $812.65 $816.71 $820.80 $824.90 $829.02 $833.17 $837.34 $841.52 $845.73 $849.96 $854.21 $858.48 $862.77 $867.09 $871.42 $875.78 $880.16 $884.56 $888.98 $893.43 $897.89 $902.38 $906.89 $911.43 $915.99 $920.57 $925.17 $929.79 $934.44 $939.11 $943.81 $948.53 $953.27 $958.04 $962.83 $967.64 $972.48 $977.34 $982.23 $987.14

© 2019 FlatWorld

$78,903.61 $78,099.03 $77,290.42 $76,477.78 $75,661.06 $74,840.27 $74,015.37 $73,186.34 $72,353.17 $71,515.84 $70,674.32 $69,828.59 $68,978.63 $68,124.42 $67,265.94 $66,403.17 $65,536.09 $64,664.67 $63,788.89 $62,908.73 $62,024.17 $61,135.19 $60,241.77 $59,343.88 $58,441.50 $57,534.60 $56,623.17 $55,707.19 $54,786.62 $53,861.46 $52,931.66 $51,997.22 $51,058.10 $50,114.29 $49,165.76 $48,212.49 $47,254.45 $46,291.62 $45,323.98 $44,351.50 $43,374.16 $42,391.93 $41,404.78

323 324 325 326 327 328 329 330 331 332 333 334 335 336 337 338 339 340 341 342 343 344 345 346 347 348 349 350 351 352 353 354 355 356 357 358 359 360

$41,404.78 $40,412.71 $39,415.67 $38,413.65 $37,406.61 $36,394.55 $35,377.42 $34,355.20 $33,327.88 $32,295.42 $31,257.79 $30,214.98 $29,166.96 $28,113.69 $27,055.16 $25,991.33 $24,922.19 $23,847.70 $22,767.83 $21,682.57 $20,591.88 $19,495.74 $18,394.12 $17,286.99 $16,174.32 $15,056.09 $13,932.27 $12,802.83 $11,667.75 $10,526.98 $9,380.52 $8,228.32 $7,070.36 $5,906.61 $4,737.04 $3,561.63 $2,380.33 $1,193.14

$1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10 $1,199.10

$207.02 $202.06 $197.08 $192.07 $187.03 $181.97 $176.89 $171.78 $166.64 $161.48 $156.29 $151.07 $145.83 $140.57 $135.28 $129.96 $124.61 $119.24 $113.84 $108.41 $102.96 $97.48 $91.97 $86.43 $80.87 $75.28 $69.66 $64.01 $58.34 $52.63 $46.90 $41.14 $35.35 $29.53 $23.69 $17.81 $11.90 $5.97

$992.08 $997.04 $1,002.02 $1,007.03 $1,012.07 $1,017.13 $1,022.21 $1,027.33 $1,032.46 $1,037.62 $1,042.81 $1,048.03 $1,053.27 $1,058.53 $1,063.83 $1,069.14 $1,074.49 $1,079.86 $1,085.26 $1,090.69 $1,096.14 $1,101.62 $1,107.13 $1,112.67 $1,118.23 $1,123.82 $1,129.44 $1,135.09 $1,140.76 $1,146.47 $1,152.20 $1,157.96 $1,163.75 $1,169.57 $1,175.42 $1,181.29 $1,187.20 $1,193.14

$40,412.71 $39,415.67 $38,413.65 $37,406.61 $36,394.55 $35,377.42 $34,355.20 $33,327.88 $32,295.42 $31,257.79 $30,214.98 $29,166.96 $28,113.69 $27,055.16 $25,991.33 $24,922.19 $23,847.70 $22,767.83 $21,682.57 $20,591.88 $19,495.74 $18,394.12 $17,286.99 $16,174.32 $15,056.09 $13,932.27 $12,802.83 $11,667.75 $10,526.98 $9,380.52 $8,228.32 $7,070.36 $5,906.61 $4,737.04 $3,561.63 $2,380.33 $1,193.14 $0.00

Section 5. The Bigger Picture 

Describe how NPV and annuity and perpetuity calculations fit into the larger picture of © 2019 FlatWorld



finance.

Explain how financial value is only one piece of larger ethical considerations.

Section Outline 

While we can solve for loan payments and present values, additional considerations such as supporting a local business may factor into our decision.



When a manager is granting a loan where the borrower may face difficulties paying, what is the manager’s responsibility to the borrower?



If legislation is introduced to lower minimum payments on credit cards, would this benefit or harm consumers?

Key Takeaways 

NPV and the annuity and perpetuity equations can be used to arrive at financial values for more complex investments.



Financial value is not the end of the calculation, as other considerations, especially ethical issues, must be factored in.

Answers to Exercises

a. Typically more. If Ted pays interest below the market rate, the difference is usually “negative amortization” and causes the amount owed to go up! b. It might make financial sense, if the cost of leaving the house during the repossession is low enough. Some businesses do actually use this type of “strategic default”, but Ted should be aware that a foreclosure will have a negative impact on his credit score and he might not be able to borrow for a mortgage again for many years. c. Answers can vary depending upon the ethical framework used. Many would say “no” because Ted has an obligation to pay his debts, although a counter-argument can be made that a portion of the interest banks charge is exactly to cover the possibility of default (and these types of adjustable mortgages do often have a higher risk premium built in).

© 2019 FlatWorld

Section 6. End-of-Chapter Exercises Answers to Exercises 1. PV of annuity = $9,818,147.41; so the lump sum payment is the better value.

2. a. 4.21%, assuming he withdraws the first $100,000 immediately (annuity due); 3.93% if he can wait until the end of the year to withdraw. b. 4.34%, assuming he withdraws the first $100,000 immediately (annuity due); 4.07% if he can wait until the end of the year to withdraw.

3. $50 million * .08 = $4 million 4. a. $123.77 b. $125 5. PMT=$1,912.48

month 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

beg.

Balance $250,000.00 $249,025.02 $248,046.38 $247,064.07 $246,078.08 $245,088.38 $244,094.98 $243,097.86 $242,096.99 $241,092.37 $240,083.98 $239,071.81 $238,055.85 $237,036.08 $236,012.48 $234,985.04 $233,953.75 $232,918.60 $231,879.56 $230,836.62 $229,789.78 $228,739.01

pmt $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48

interest $937.50 $933.84 $930.17 $926.49 $922.79 $919.08 $915.36 $911.62 $907.86 $904.10 $900.31 $896.52 $892.71 $888.89 $885.05 $881.19 $877.33 $873.44 $869.55 $865.64 $861.71 $857.77

principal $974.98 $978.64 $982.31 $985.99 $989.69 $993.40 $997.13 $1,000.87 $1,004.62 $1,008.39 $1,012.17 $1,015.96 $1,019.77 $1,023.60 $1,027.44 $1,031.29 $1,035.16 $1,039.04 $1,042.93 $1,046.85 $1,050.77 $1,054.71

© 2019 FlatWorld

end balance $249,025.02 $248,046.38 $247,064.07 $246,078.08 $245,088.38 $244,094.98 $243,097.86 $242,096.99 $241,092.37 $240,083.98 $239,071.81 $238,055.85 $237,036.08 $236,012.48 $234,985.04 $233,953.75 $232,918.60 $231,879.56 $230,836.62 $229,789.78 $228,739.01 $227,684.29

23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65

$227,684.29 $226,625.63 $225,562.99 $224,496.37 $223,425.75 $222,351.11 $221,272.44 $220,189.73 $219,102.96 $218,012.11 $216,917.17 $215,818.13 $214,714.97 $213,607.66 $212,496.21 $211,380.59 $210,260.78 $209,136.78 $208,008.55 $206,876.10 $205,739.41 $204,598.45 $203,453.21 $202,303.67 $201,149.83 $199,991.66 $198,829.14 $197,662.27 $196,491.02 $195,315.38 $194,135.33 $192,950.85 $191,761.93 $190,568.56 $189,370.71 $188,168.36 $186,961.51 $185,750.13 $184,534.21 $183,313.73 $182,088.68 $180,859.03 $179,624.76

$1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48

$853.82 $849.85 $845.86 $841.86 $837.85 $833.82 $829.77 $825.71 $821.64 $817.55 $813.44 $809.32 $805.18 $801.03 $796.86 $792.68 $788.48 $784.26 $780.03 $775.79 $771.52 $767.24 $762.95 $758.64 $754.31 $749.97 $745.61 $741.23 $736.84 $732.43 $728.01 $723.57 $719.11 $714.63 $710.14 $705.63 $701.11 $696.56 $692.00 $687.43 $682.83 $678.22 $673.59

$1,058.67 $1,062.64 $1,066.62 $1,070.62 $1,074.64 $1,078.67 $1,082.71 $1,086.77 $1,090.85 $1,094.94 $1,099.04 $1,103.17 $1,107.30 $1,111.45 $1,115.62 $1,119.81 $1,124.01 $1,128.22 $1,132.45 $1,136.70 $1,140.96 $1,145.24 $1,149.53 $1,153.84 $1,158.17 $1,162.51 $1,166.87 $1,171.25 $1,175.64 $1,180.05 $1,184.48 $1,188.92 $1,193.38 $1,197.85 $1,202.34 $1,206.85 $1,211.38 $1,215.92 $1,220.48 $1,225.06 $1,229.65 $1,234.26 $1,238.89

© 2019 FlatWorld

$226,625.63 $225,562.99 $224,496.37 $223,425.75 $222,351.11 $221,272.44 $220,189.73 $219,102.96 $218,012.11 $216,917.17 $215,818.13 $214,714.97 $213,607.66 $212,496.21 $211,380.59 $210,260.78 $209,136.78 $208,008.55 $206,876.10 $205,739.41 $204,598.45 $203,453.21 $202,303.67 $201,149.83 $199,991.66 $198,829.14 $197,662.27 $196,491.02 $195,315.38 $194,135.33 $192,950.85 $191,761.93 $190,568.56 $189,370.71 $188,168.36 $186,961.51 $185,750.13 $184,534.21 $183,313.73 $182,088.68 $180,859.03 $179,624.76 $178,385.87

66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108

$178,385.87 $177,142.34 $175,894.14 $174,641.26 $173,383.68 $172,121.38 $170,854.36 $169,582.58 $168,306.03 $167,024.69 $165,738.55 $164,447.59 $163,151.78 $161,851.12 $160,545.58 $159,235.14 $157,919.79 $156,599.51 $155,274.27 $153,944.07 $152,608.87 $151,268.67 $149,923.45 $148,573.18 $147,217.84 $145,857.43 $144,491.91 $143,121.27 $141,745.49 $140,364.55 $138,978.44 $137,587.12 $136,190.59 $134,788.82 $133,381.80 $131,969.50 $130,551.90 $129,128.99 $127,700.74 $126,267.13 $124,828.15 $123,383.77 $121,933.98

$1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48

$668.95 $664.28 $659.60 $654.90 $650.19 $645.46 $640.70 $635.93 $631.15 $626.34 $621.52 $616.68 $611.82 $606.94 $602.05 $597.13 $592.20 $587.25 $582.28 $577.29 $572.28 $567.26 $562.21 $557.15 $552.07 $546.97 $541.84 $536.70 $531.55 $526.37 $521.17 $515.95 $510.71 $505.46 $500.18 $494.89 $489.57 $484.23 $478.88 $473.50 $468.11 $462.69 $457.25

$1,243.54 $1,248.20 $1,252.88 $1,257.58 $1,262.29 $1,267.03 $1,271.78 $1,276.55 $1,281.34 $1,286.14 $1,290.96 $1,295.80 $1,300.66 $1,305.54 $1,310.44 $1,315.35 $1,320.28 $1,325.24 $1,330.20 $1,335.19 $1,340.20 $1,345.23 $1,350.27 $1,355.33 $1,360.42 $1,365.52 $1,370.64 $1,375.78 $1,380.94 $1,386.12 $1,391.31 $1,396.53 $1,401.77 $1,407.03 $1,412.30 $1,417.60 $1,422.91 $1,428.25 $1,433.61 $1,438.98 $1,444.38 $1,449.79 $1,455.23

© 2019 FlatWorld

$177,142.34 $175,894.14 $174,641.26 $173,383.68 $172,121.38 $170,854.36 $169,582.58 $168,306.03 $167,024.69 $165,738.55 $164,447.59 $163,151.78 $161,851.12 $160,545.58 $159,235.14 $157,919.79 $156,599.51 $155,274.27 $153,944.07 $152,608.87 $151,268.67 $149,923.45 $148,573.18 $147,217.84 $145,857.43 $144,491.91 $143,121.27 $141,745.49 $140,364.55 $138,978.44 $137,587.12 $136,190.59 $134,788.82 $133,381.80 $131,969.50 $130,551.90 $129,128.99 $127,700.74 $126,267.13 $124,828.15 $123,383.77 $121,933.98 $120,478.75

109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151

$120,478.75 $119,018.06 $117,551.89 $116,080.23 $114,603.05 $113,120.33 $111,632.04 $110,138.18 $108,638.72 $107,133.63 $105,622.90 $104,106.50 $102,584.41 $101,056.62 $99,523.10 $97,983.83 $96,438.79 $94,887.95 $93,331.30 $91,768.80 $90,200.45 $88,626.22 $87,046.09 $85,460.03 $83,868.02 $82,270.04 $80,666.07 $79,056.09 $77,440.06 $75,817.98 $74,189.81 $72,555.54 $70,915.14 $69,268.59 $67,615.87 $65,956.94 $64,291.80 $62,620.41 $60,942.75 $59,258.80 $57,568.54 $55,871.94 $54,168.98

$1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48

$451.80 $446.32 $440.82 $435.30 $429.76 $424.20 $418.62 $413.02 $407.40 $401.75 $396.09 $390.40 $384.69 $378.96 $373.21 $367.44 $361.65 $355.83 $349.99 $344.13 $338.25 $332.35 $326.42 $320.48 $314.51 $308.51 $302.50 $296.46 $290.40 $284.32 $278.21 $272.08 $265.93 $259.76 $253.56 $247.34 $241.09 $234.83 $228.54 $222.22 $215.88 $209.52 $203.13

$1,460.69 $1,466.17 $1,471.66 $1,477.18 $1,482.72 $1,488.28 $1,493.86 $1,499.47 $1,505.09 $1,510.73 $1,516.40 $1,522.08 $1,527.79 $1,533.52 $1,539.27 $1,545.04 $1,550.84 $1,556.65 $1,562.49 $1,568.35 $1,574.23 $1,580.13 $1,586.06 $1,592.01 $1,597.98 $1,603.97 $1,609.99 $1,616.02 $1,622.08 $1,628.17 $1,634.27 $1,640.40 $1,646.55 $1,652.73 $1,658.92 $1,665.14 $1,671.39 $1,677.66 $1,683.95 $1,690.26 $1,696.60 $1,702.96 $1,709.35

© 2019 FlatWorld

$119,018.06 $117,551.89 $116,080.23 $114,603.05 $113,120.33 $111,632.04 $110,138.18 $108,638.72 $107,133.63 $105,622.90 $104,106.50 $102,584.41 $101,056.62 $99,523.10 $97,983.83 $96,438.79 $94,887.95 $93,331.30 $91,768.80 $90,200.45 $88,626.22 $87,046.09 $85,460.03 $83,868.02 $82,270.04 $80,666.07 $79,056.09 $77,440.06 $75,817.98 $74,189.81 $72,555.54 $70,915.14 $69,268.59 $67,615.87 $65,956.94 $64,291.80 $62,620.41 $60,942.75 $59,258.80 $57,568.54 $55,871.94 $54,168.98 $52,459.63

152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180

$52,459.63 $50,743.87 $49,021.67 $47,293.02 $45,557.89 $43,816.25 $42,068.07 $40,313.35 $38,552.04 $36,784.12 $35,009.58 $33,228.38 $31,440.51 $29,645.93 $27,844.61 $26,036.55 $24,221.70 $22,400.05 $20,571.57 $18,736.23 $16,894.01 $15,044.87 $13,188.81 $11,325.78 $9,455.77 $7,578.75 $5,694.69 $3,803.56 $1,905.34

$1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48 $1,912.48

$196.72 $190.29 $183.83 $177.35 $170.84 $164.31 $157.76 $151.18 $144.57 $137.94 $131.29 $124.61 $117.90 $111.17 $104.42 $97.64 $90.83 $84.00 $77.14 $70.26 $63.35 $56.42 $49.46 $42.47 $35.46 $28.42 $21.36 $14.26 $7.15

$1,715.76 $1,722.19 $1,728.65 $1,735.13 $1,741.64 $1,748.17 $1,754.73 $1,761.31 $1,767.91 $1,774.54 $1,781.20 $1,787.88 $1,794.58 $1,801.31 $1,808.07 $1,814.85 $1,821.65 $1,828.48 $1,835.34 $1,842.22 $1,849.13 $1,856.06 $1,863.03 $1,870.01 $1,877.02 $1,884.06 $1,891.13 $1,898.22 $1,905.34

$50,743.87 $49,021.67 $47,293.02 $45,557.89 $43,816.25 $42,068.07 $40,313.35 $38,552.04 $36,784.12 $35,009.58 $33,228.38 $31,440.51 $29,645.93 $27,844.61 $26,036.55 $24,221.70 $22,400.05 $20,571.57 $18,736.23 $16,894.01 $15,044.87 $13,188.81 $11,325.78 $9,455.77 $7,578.75 $5,694.69 $3,803.56 $1,905.34 $0.00

6. PV of annuity=$2,114,091.68 so take the annuity, not the lump sum.

7. PMT=$5,882.52 8. a. A timeline version of: year CF

0 1 2 3 4 5 ($200,000.00) $15,000.00 $80,000.00 $80,000.00 $80,000.00 $50,000.00

b. Draw arrows for each flow to year 5 c. Draw arrows for each flow back to year 0 d. C, because he needs to make the decision now.

9. The effective annual rate of A is 14.93%, and B is 16.64%. Since he is paying the interest, he wants the lower effective rate, so he should choose A. © 2019 FlatWorld

© 2019 FlatWorld

Chapter 7 Securities Markets “To Market, To Market . . . “ 

Markets can be thought of as a physical place where goods are exchanged.



More broadly, a market can be formed by the beliefs in individuals. Two defining characteristics of a market are connections between individuals (or companies) and exchange of some sort.

Section 1. Financial Environment: Institutions and Markets 

Describe the difference between a commercial bank and an investment bank.



Explain why commercial banks and investment banks have been merging into “megabanks”.



Describe markets, especially with regards to physical vs. electronic presence.

Section Outline 

Commercial banks provide checking and savings accounts while investment banks are geared to servicing corporations and market operations.



Commercial and investment banks have been merging since 1999; creating concern that their presence makes them “too big to fail”.



Markets exist for trading any product. Historically financial markets were segmented by region and product. Today technology has allowed for linkages amount markets.

Key Takeaways

© 2019 FlatWorld



Commercial banks focus on retail customers and small businesses; investment banks focus on capital markets for larger businesses.



Since 1999, many commercial banks and investment banks have been merging after the elimination of government restrictions on the practice.



Many markets still have a physical presence, but the bulk of volume is now electronic.

Key Terms    

Commercial banks: A bank that provides checking and savings accounts for depositors and loans for borrowers.

Investment banks: A bank that provides services geared to corporations and market operations. “too big to fail”: A label that means governments are pressured into supporting a company when it is in distress, as the alternative of letting the company become insolvent is perceived to be even worse.

Over-the-counter (OTC) markets: Decentralized market with no physical location or formal recognition.

Answers to Exercises 1. If the costs of having the company fail are larger than the costs of the bailout, then it might be worth it. For example, many think that the failure of the large banks in 2008 could have caused trillions of losses if they hadn’t been bailed out. But if bailouts are common, then companies might take riskier actions expecting to be bailed out if a large downside outcome happens.

Section 2. Regulation of Financial Institutions 

Describe the main regulatory acts for US markets and institutions.

© 2019 FlatWorld

Section Outline 

The Glass-Steagall Act of 1933 separated investment from commercial banks and established the FDIC, which insures deposits at commercial banks.



The Securities Act of 1933 and Securities Exchange Act of 1934 created the SEC and regulations governing the sale of securities.



After the financial crisis, the Dodd-Frank Act was passed to improve oversight.

Key Takeaways 

Regulation is constantly changing, and a financial manager should monitor regulations that affect his or her business.

Key Terms     

Glass-Steagall Act of 1933: Imposed banking reforms on relationships between investment and commercial banks and established the FDIC. Securities Act of 1933: Limited affiliations between commercial and investment banks.

Securities Exchange Act of 1934: Further regulated financial markets and established the SEC. Securities and Exchange Commission (SEC): Federal agency responsible for regulating securities and enforcing federal securities laws.

Dodd-Frank Wall Street Reform and Consumer Protection Act: Changed American financial regulatory environment by improving accountability and transparency.

Answers to Exercises 1. Answers can vary, but most will probably answer that, on the whole, regulations are a hindrance to the financial institutions themselves. But the existence of the regulations might increase public trust in the institutions, causing them to benefit. Not a clear answer, but a good start for discussion.

© 2019 FlatWorld

Section 3. Modern History of Financial Crises   

Describe recurrent themes of financial crises.

Enumerate recent financial crises.

Describe how financial crises can relate to the business cycle.

Section Outline 

Financial crises are not new.



The most significant crisis of the 20th century was the Great Depression, lasting from the stock market crash of 1929 to World War II.



More recently, we have witnessed the 1987 stock market crash, the savings and loan crisis, the liquidation of Long Term Capital in 1998, the dot.com bubble and burst of 2000-2001, and the housing bubble/financial crisis.



Financial crises are tied to the business cycle and asset bubbles.

Key Takeaways 

Financial crises usually boil down to issues of trust: either trust in the value of an asset, or of an entity like a government or bank.



Financial crises often correlate with the down-swing of a business cycle, though it isn’t always clear which caused the other.

Key Terms   

Solvency: The ability of an entity to successfully repay debt.

Run on the bank: When investors have doubts about a banks solvency, choosing to withdraw all deposited funds.

Business cycle: The periodic rise and fall of nations’ gross domestic product observed over years. © 2019 FlatWorld



Asset bubbles: A type of asset (like real estate, technology stocks, or tulips) rises dramatically in valuation seemingly well beyond its intrinsic value.

Answers to Exercises 1. Answers include: excessive risk taking by banks, the business cycle, wars, currency value fluctuations, tight money supply by the central bank, loss of confidence in banks, etc.

2. Answers include: higher reserve requirements, forbidding speculative trading, risk reporting, more oversight by the Federal Reserve.

Section 4. Types of Financial and Other Traded Assets  

Describe commonly traded assets.

Explain the concepts of liquidity and fungibility.

Section Outline 

Markets improve the liquidity, or ease of trading, an asset.



Certain assets are easier to trade due to fungibility, ease of transfer or storage, or regulation.



More liquid assets include stock, bonds and commodities, while less liquid assets include alternative investments, real estate and private equity.



Derivatives are securities where the value is derived from another asset.

Key Takeaways 

Many different assets are traded, and each has different features and risks.



One goal of markets is to increase the liquidity of assets.

© 2019 FlatWorld

Key Terms          

Liquidity of assets: The ease at arranging a trade between a buyer and a seller of an asset.

Fungibility: The ability to substitute one instance of the asset for another. Gasoline is very fungible, since any one gallon is very like another, whereas a unique work of art is not fungible.

Commodities: Agriculture products (like wheat, corn, pork bellies, or coffee), metals (like gold, silver, or iron), energy products (like oil or electricity), or a host of other highly fungible physical products.

Real estate: Land and the fixed developments upon it.

Alternative investments: Art, antiques, wine, and collectibles (like rare baseball cards) are extremely illiquid and hard to value.

Security: Financial assets with contracts written so that the owner of the instrument has the ability to transfer the benefits (that is, sell it) to another.

Bonds: Securitized loans.

Shares of stock: Securitized ownership in a corporation.

Private equity: Investments in non-public companies.

Derivatives: Any financial assets which primarily derive their value from any other asset.

Answers to Exercises 1. It usually helps both! If a seller needs to sell in a hurry, or a buyer wants to buy sooner rather than later, then greater liquidity will mean less of a difference between a trade that is done hastily and a trade that has been “shopped around”.

2. Financial assets involve a contract of future transfers of wealth. They typically don’t have a “physical” component where the owner can extract value a different way (e.g. the way a farmer could choose to eat his wheat, or a home owner can live in a house).

Section 5. The Bigger Picture  

Explain how financial markets and institutions fit into financial decision making.

Discuss ethical implications of financial institutions and markets.

Section Outline © 2019 FlatWorld



While managers must be cognizant of market reaction, they must not be swayed to deceive investors.

Key Takeaways 

Management needs to be able to “think like an investor”.



Keeping the markets happy is important, but not if it means misleading statements or unethical behavior.

Answers to Exercises 1. Answers will vary, but may include: there is a benefit to the families that might not be able to afford a house otherwise, but an unanswered question is how likely the mortgages are to be repaid. Both the bank and the families will likely lose out if the bank needs to foreclose on an unpaid mortgage. Even if the families won’t default, perhaps they shouldn’t be buying the house if they would be “house poor”, i.e. not having enough income after mortgage payments. There may be legal standards regulating how low credit standards are allowed to be lowered. Other stakeholders of the bank might be affected, positively or negatively, by the changed standards.

Section 6. End-of-Chapter Problems Answers to Exercises 1. Reactive. Much legislation takes places a few years after a financial crisis, usually claiming to address some of the causes of the crisis.

2. If assets aren’t fungible, then they might only have regional value. Differing laws or levels of trust in financial markets will make certain assets unavailable or unprofitable.

Different currencies (and the currency risk that entails) can cause a preference for certain assets in one market over another.

© 2019 FlatWorld

Chapter 8 Interest Rates and Bond Valuation My Word Is My Bond 

While banks are involved in making loans to individuals or small businesses, government entities and corporations have other options.

Section 1. Bonds and Interest Rates 

Explain what a bond is and who issues bonds.



List and describe the key features of a bond.



Calculate the coupon rate given the annual coupon payments and the par value of a bond.

Section Outline 

Government entities and corporation issue bonds.



The coupon rate is (usually) a fixed amount the issuer, or the borrower, pays the bond holder.

Key Takeaways 

Bonds make coupon payments until the maturity date, at which point the final coupon payment and the par value are due.



The coupon rate is the annual coupon payments of the bond divided by the par value of the bond.



Coupon rates don’t change over the life of the bond for almost all bonds.

© 2019 FlatWorld

Key Terms        

Securitize: To make a series of cash flows into a tradable instrument.

Bond: A loan packaged as a tradable security, typically with a periodic interest payment and a repayment of principal at maturity.

Coupon payments: The periodic payments of a bond, typically paid semiannually.

Maturity date: The date on which the final coupon payment and the principal of the bond is due.

Par value: The principal amount of the bond.

Coupon rate: The annual total of the coupon payments expressed as a percentage of the par value.

Bond indenture: The contract which stipulates all of the specific details of a bond, including conditions for repayment and default.

Covenants: Specific items in a bond indenture.

Answers to Exercises 1. a. Coupon rate: the percentage of the bond’s face value paid annually. b. Maturity date: the date the face value will be repaid. c. Par value or face value: the principal amount of the bond. d. Bond indenture: the contract that stipulates the specific details of the bond.

2. The coupon doesn’t change!

3. No. If interest rates change, the coupon rate doesn’t change.

Section 2. Credit Risk 

Describe credit risk.



Explain why US government securities are used as a proxy for a risk-free asset.



Explain how ratings agencies help to identify credit risk.

Section Outline © 2019 FlatWorld



Credit risk is the risk that the borrower does not make all payments. Typically this is the risk of default.



Sometimes credit risk can be addressed by collateral, or assets pledged to secure payment.

Key Takeaways 

Credit risk should be a major consideration when evaluating bonds.



US Government securities are used as a proxy for the risk-free rate.



Ratings agencies help to evaluate credit risk, but should not be taken as absolute truth.

Key Terms   

Credit risk: The uncertainty in future cash flows due to possibility that the borrower will not pay.

Default risk: The most common credit risk, which in the extreme occurs when the company doesn’t have the cash to pay the necessary scheduled payment (or chooses not to).

Collateral: Assets pledged to secure repayment.

Answers to Exercises 1. A bond is in default when the issuing entity fails to meet an obligation provided for in the bond indenture. Usually this is a missed or underpaid interest or principal payment, but it can be for other broken covenants. Ratings agencies typically use “D” to specify bonds in default.

2. Speculative debt.

Section 3. Bond Yield © 2019 FlatWorld

   

Explain the relationship between the real interest rate, the nominal interest rate, and inflation.

Calculate a nominal interest rate, given the real interest rate and an inflation rate, using the Fisher equation and the more common approximation.

Describe the relationship between bond prices and yields.

Calculate the risk premium of an asset, given the risk-free return and the expected return of the asset.

Section Outline 

The nominal interest rate is the quoted rate of an investment.



The real interest rate is the nominal rate adjusted for inflation.



A bond’s yield to maturity is the return an investor would receive at the current price of the bond if all expected cash flows are made.



Investors will require a higher yield on a bond given the risk premium of the bond.

Key Takeaways 

Real Interest Rate + Inflation = Nominal Interest Rate (when inflation is reasonable).



Bond prices go up, yields go down. Bond prices go down, yields go up.



The risk premium of an asset is the extra amount of yield needed above the risk-free rate to compensate for the higher level of risk

Key Terms   

Inflation: The deterioration of the purchasing power of a currency.

Nominal interest rate: The interest rate that compensates for opportunity cost and inflation factored together.

Risk premium: The amount of return required by investors over the risk-free asset. © 2019 FlatWorld

Answers to Exercises 1. All other things equal, the nominal rate of interest should rise if inflations expectations increase. Bond prices should fall, as they move inversely with interest rates.

2. Approx. 5%. Fisher: 1.02*1.03-1=5.06%; Approx. 17%. Fisher: 1.02*1.15-1=17.3% 3. Their risk premium should increase. This should cause the required rate of the bond to rise, causing the price of the bonds to fall.

Section 4. Bond Valuation   

Calculate the price of a bond.

Explain how bond prices are quoted.

Calculate the YTM of a bond.

Section Outline 

Bond prices are often quoted as a percentage of the par value of the bond.



Bonds are typically quoted as “clean prices”, meaning they ignore accrued interest.



Dirty prices include the accrued interest.

Key Takeaways 

Use TVM equations or Excel functions to solve for the price or yield of bonds.



Bond prices are quoted as a percent of par, so they should be near 100. Above 100, the bond is trading at a premium, and, below 100, at a discount.

Answers to Exercises 1. The price is above par if the bond is trading at a premium, so the YTM should be below the coupon rate (prices and yields move in inverse directions). © 2019 FlatWorld

2. 96.01 is the quoted price, no matter the par value, since quoted prices are given as a percentage of par.

3. The YTM today is 4.86% given the quoted price. One year from now, if the yield is constant, the quoted price should be 106.70.

Section 5. The Bigger Picture  

Describe how bonds fit into the larger picture of finance.

Explain ethical considerations regarding bonds.

Section Outline 

Companies have an incentive to make a firm appear safer as this lowers interest costs.



While ratings companies are meant to be objective, they collect fees for each issue, which creates a conflict of interest.

Key Takeaways 

Bonds allow entities to raise capital.



Companies can try to manipulate perception to influence ratings agencies and potential cost of borrowing.



Investors should remember that buying a bond is, at least indirectly, supporting the operations of the corporation, government, etc. that issued the bond.

Answers to Exercises 1. The investor most likely will need to weigh the consequences of supporting the government financially vs. the costs if not, including where else the investor can put their money (for example, if the money is already in the country, the government might not allow the investor to remove it). Different ethical systems will arrive at different

© 2019 FlatWorld

answers. Some might determine that supporting such a regime is unethical even if the consequences are famine for the people. Others might arrive at a different conclusion.

2. At least indirectly, yes. Investors are willing to pay more for an asset if it is liquid (that is, they can resell it), which would drive down the funding cost for the company.

Section 6. End-of-Chapter Problems Answers to Exercises 1.

2.

3.

4.

5.

$42.50 3.5% 15,000 yen annually, so 7,500 yen every payment 10% B+ is riskier, as it is the lower rating. Therefore, it should also have a higher yield, all other things being equal (although, possibly not, for example if the bonds pay in different currencies with different inflation expectations). The coupon rate can’t be predicted, since that is set by the company at the time of issue.

6. Approx.: 6.5%; Fisher equation: 1.025*1.04-1=6.6% 7. 9%-5%=4% 8. Security B 9. 10.04% 10. 99.01 11. 5.50% (hint: use the =pmt() function with pv=-821.70; fv=1000; nper=15*2; rate=7.5%/2 to get the coupon payment) 12. The price should be less than par (a discount bond). We don’t know more, since we don’t know the maturity of the bond.

13. Bond A has a quoted price of 108.84 before the change, and 102.84 after. Bond B has a quoted price of 126.52 before the rate change, and 119.89 after. Bond A is more sensitive (5.51% price move vs. 5.24%). Usually the lower the coupon, the more sensitive the bond is to rate changes (all else equal).

14. PV=$666.34 for a quoted price of 66.63

© 2019 FlatWorld

Chapter 9 Stock Valuation How Much Is a Piece of a Company Worth?  What drives the value of a share of stock? What factors go into analyzing the price of a share of stock?

Section 1. Common and Preferred Stock 

Explain the typical features of and differences between preferred stock and common stock.



Describe why managers care about a company’s stock price.

Section Outline 

Preferred stock is equity with fixed dividend payments and acts like a hybrid between common stock and bonds.



Common stock comprises the bulk of equity issued, and represents a residual claim on firm assets.

Key Takeaways 

Fundamentally, the value of stock is dependent on the value of the residual claim of the firm’s assets.



Preferred stock dividends are quoted as a percentage of their $100 par value. Common stock dividends are decided by the board and thus tend to fluctuate more.



Managers care about stock prices because they can be replaced if shareholders are displeased, the company may need to raise equity financing in the future, and they may have been given shares themselves as compensation. © 2019 FlatWorld

Key Terms    

Dividends: Payouts (usually in cash) to the owners of a company proportional to their ownership of the company.

Preferred stock: A type of equity that acts as hybrid of bonds and common stock, with no maturity date and fixed dividend payments.

Common stock: The bulk of equity issues, representing a residual claim on firm assets.

Residual claim: The value of assets leftover after all other claims have been paid.

Answers to Exercises 1. 6% of the par value. So if the preferred stock has the usual $100 par, the annual dividend would be $6.00 per share.

2. Usually the common stock if the company is doing extremely well. The value of the preferred stock is capped, since the dividend payments won’t increase, but the gains from common stock are only limited by the success of the company (since it is a claim on the company’s equity).

Section 2. Dividend Discount Model 

Explain where the value of a stock is ultimately derived.



Calculate a stock valuation given a dividend growth rate or a stream of dividends.

Section Outline 

The value of a stock ultimately comes from the cash flows the company creates.



The dividend model values a company by discounting all future payments back to the present.

© 2019 FlatWorld

Key Takeaways 

Every stock must be fundamentally worth the present value of the future cash flows.



Because many stocks pay in perpetuity, the perpetuity formulas are useful for dividends growing at a constant rate. This formula will only work accurately with a constant rate.



For stocks with dividends not currently growing at a constant rate, the individual dividends need to be accounted for first, then a future value for the stock can be used for when the dividends are in the constant growth period.

Answers to Exercises 1.

2.

3.

4.

$112.50 (assuming $100 par) $0.25 quarterly div = $1 annual div. P0=$1(1.03)/(.11-.03)=$12.88 $0.10 quarterly div = $0.40 annual div. P3=0.40(1.05)/(.10-.05)=$8.40 P0=PV(P3)=$6.31 $13.16

Section 3. Market Multiples Approach  

Explain how to use a market multiple to evaluate a stock price.

Calculate a stock valuation given the necessary data using a market multiple.

Section Outline 

Market multiples is an approach to value a firm by comparing some “per share” variable to its peers.

Key Takeaways 

Though using P/E ratios to value a stock is the most common approach, any key metric can be chosen (though some will be more appropriate than others!). © 2019 FlatWorld



Comparing to the industry, a competitor, or the same company over time can all yield valuable information about the stock’s value.



Garbage in, garbage out. The accuracy of this method will depend on the usefulness of the metric used, and no one measure can fully capture the complexity of a company.

Key Terms 

Market multiples approach: A popular approach to stock valuation that uses the ratio of stock price per share relative to some other “per share” variable; similar businesses should demonstrate similar ratios.

Answers to Exercises 1. Competitor’s P/E=$36/$2=18 times. Our EPS=$5 * 18 times = $90 per share 2. Many reasons. The most common reason is a change in projected earnings growth, but changing risk factors, changing interest rates, etc. can also play a part.

3. With no (or negative!) profit, the P/E ratio doesn’t have much meaning, since the denominator would be zero (or negative!). By using sales in the denominator, we avoid the issue of having a denominator close to zero.

Section 4. Free Cash Flow Apporach  

Calculate the valuation of a company based on FCFs and WACC. Calculate the value of a share of stock using the FCF method.

Section Outline 

The free cash flow approach is similar to the dividend discount model except free cash flows are discounted.

© 2019 FlatWorld



In the dividend discount model the cost of equity is used to discount cash flows. Here the WACC is used to discount free cash flows since these cash flows are available for distribution for ALL investors in the firm.

Key Takeaways 

Calculating the value of a company using the FCF method tends to be more accurate, so it is used in practice much more than the DDM.



The FCF method can be very sensitive to assumed long-term growth rates.

Key Terms 

Weighted average cost of capital (WACC): An average of the returns required by equity holders and debt holders weighted by the company’s relative usage of each.

Answers to Exercises 1. Terminal value=$6(1.05)/(.08-.05)=$210 million. Value today=$180.91 million (using the NPV function). At 3% projected growth past terminal, the terminal value drops to $123.6 million, causing the value today to be $112.23 million.

2. $150 million. $15 per share.

Section 5. The Bigger Picture  

Describe how stock fits into the larger picture of finance.

Explain ethical considerations regarding stock.

Section Outline 

Activist shareholders may use their influence to push their own agendas; firms often make provisions to limit the influence of investors. © 2019 FlatWorld



Managers may try to manipulate earnings announcements if the are concerned with the reaction of the market.

Key Takeaways 

Shareholders are both a source of capital and enactors of corporate governance. Through both of these can they influence management’s behavior.

Answers to Exercises 1. Answers can vary, but usually the managers should not practice earnings “smoothing”, since they might be obscuring data that shareholders need to accurately gauge the performance of the stock. Stockholders should have access to the most accurate data to make their decisions.

2. She could sell her shares, which would send a signal. She could also try to contact management, or even try to get a proposal in front of the board; both are forms of shareholder activism.

Section 6. End-of-Chapter Problems

Answers to Exercises 1. The problem presumably means “8% annual dividend”. If the stock has a par value of $100, then the return is $8/$133.33=.06=6% 2. The problem presumably means “7% dividend”. If the stock has a par value of $100, then the price should be $7/.11=$63.64 3. 2/.09=$22.22 4. P0=$1/(.11-.05)=$16.67; P0=$1/(.10-.05)=$20 5. P0=$1.50(1.03)/(.09-.03)=$25.75 6. r=$2/$30+.02=.0867=8.67% 7. $7.60 8. P3=$2(1.05)/(.11-.05)=$35; P0=PV(P3)=$25.59 9. P5=0.50(1.06)/(.12-.06)=$8.83; P0=PV(P5)=$5.01 10. P/E=$39.75/$1.59=25 times; 25 times $1.38 = $34.50 © 2019 FlatWorld

11. P/E=$33.35/$1.15=29 times; 29 times $1.45 = $42.05 12. $2/(.07-.03)=$50 million; $25 per share 13. Terminal Value=$2.416 million*1.04/(.09-.04)=$50.25 million; Value of company (using NPV) = $40.37 million; Value of equity = ($40.37-$10-$5)=$25.37 million; $25.37 per share

© 2019 FlatWorld

Chapter 10 Assessing Risk Nothing Ventured, Nothing Gained  Life is full of uncertainty. While we can’t predict the future or shield ourselves from all risk, we can learn how to measure risk and control our exposure to it.

Section 1. Risk and Return Basics 

Explain risk and risk aversion.



Calculate the rate of return and expected rate of return for an investment.

Section Outline 

The level of risk aversion is the degree to which you prefer less risk to more risk, all else being equal.



Expected return is the weighted probability mean of an investment.

Key Takeaways 

Dealing with risk is a key part of finance, especially since most people are risk averse.



Expected future returns are the weighted average of the possible outcomes. Historical results are often used as a proxy for future expected results.



Historical results are not a guarantee of future performance!

© 2019 FlatWorld

Key Terms       

Risk: Uncertainty in outcome.

Risk aversion: The tendency for most people to prefer less risk to more risk, all else being equal.

Risk seeking: An entity who prefers a more risky alternative to a less risky one, all else being equal.

Risk neutral: An entity who is ambivalent between choices with different levels of risk, all else being equal.

Returns: For an investment, the amount of money we end with, less our invested money.

Rate of return: The ratio of our return to our investment.

Expected rate of return: The weighted mean of the possible investment outcomes; that is, each possible outcome weighted by the probability of that outcome.

Answers to Exercises 1. (200+400-500)/500=20% 2. .10*.20+.70*.10+.20*0=0.09=9% 3. 0.6%, which is the equally weighted (arithmetic) average. Future returns might be different if something has fundamentally changed (such as interest rates rising, or a company changing the focus of its business).

Section 2. Portfolios 

Calculate the returns for a portfolio of securities.



Explain the benefits of diversification.

Section Outline 

A portfolio’s return is the weighted average of the return of the portfolio’s components.



Portfolios of assets provide the investor with protection against poor returns in any one asset within the portfolio.

© 2019 FlatWorld

Key Takeaways 

Portfolio returns are a weighted (by % of investment) average of the components.



Diversification causes the portfolio’s returns to be less extreme than our best or worst investments.

Key Terms  

Portfolio: A collection of financial assets.

Diversification: Holding a portfolio of different assets so as not to concentrate exposure on one particular asset.

Answers to Exercises 1. 2.3% is the weighted average.

2. ABC=27.78%; DEF=55.56%; GHI=16.67% 3. 6.72%

Section 3. Market Efficiency  

Describe the process of price discovery.

Explain market efficiency.

Section Outline 

If a market is efficient, no one investor should be able to abnormally profit from their investments.

© 2019 FlatWorld

Key Takeaways 

If the market is at least semi-strong efficient, then analyzing public information won’t provide a trading advantage (because the price should already reflect all publicly available data).

Key Terms  





Price discovery: The process by which investors sell or buy an asset based upon their valuation of the asset. This will cause the price to shift until the equilibrium price is reached.

Efficient Market Hypothesis (EMH): The theory that the market, in aggregate, has more information than any one investor could possibly have. The market price will be reached by this information, so an investor should not be able to abnormally profit from his or her private information.

Strong form of the EMH: The belief that all public and non-public information has been accounted for by the market. Those with insider knowledge (that is, material nonpublic financial information) about companies cannot profitably trade on the information if the market is strongly efficient.

Semi-strong form of the EMH: The belief that all public information has been accounted for by the market (including financial analysis of released statements and analysts’ forecasts). If the semi-strong form is true, than investments based upon the fundamentals of a company shouldn’t be able to earn excess profits.

Answers to Exercises 1. No, she doesn’t think the markets are efficient (either strongly or semi-strongly). If she did think this, then all the information in a company’s financials should already be reflected in the current stock price.

Section 4. Standard Deviation  

Explain how standard deviation is a measure of risk.

Calculate the standard deviation of a set of returns.

© 2019 FlatWorld

Section Outline 

The standard deviation is the most basic measure of risk for an investment. It tells us to what degree potential outcomes differ from the expected return.



The coefficient of variation is the ratio of standard deviation to expected return. All else equal, people prefer a lower coefficient of variation.



The standard deviation of a portfolio is less than the average of the portfolio’s components, due to diversification.

Key Takeaways 

Standard deviation is one common measure of risk, but not the only one. It does not represent all aspects of risk.



Standard deviation of a portfolio is not the weighted average of the standard deviations of the components. It must be computed from the portfolio returns.

Key Terms 

Coefficient of variation: The ratio of the standard deviation to the mean.

Answers to Exercises 1. Weighted average of returns=9%; std. dev. =sqrt(10%*(20%-9%)^2+70%*(10%9%)^2+20%*(0%-9%)^2)=5.39% 2. =stdev.s(5%,3%,-4%,6%,-7%)=5.77% 3. Since investments in a portfolio are less than perfectly correlated (that is, they don’t always move proportionally in the same direction), gains on one asset can offset losses in another. This is the power of diversification, and causes the portfolio standard deviation to be lower than the weighted average of the standard deviations of the components.

Section 5. Market History 

Describe the historical relationship between return and risk for various financial assets. © 2019 FlatWorld

Section Outline 

In general, less liquid assets earn higher returns and exhibit higher risk.



Small stocks historically earn more than large stocks, while cash positions earn the smallest returns. The standard deviation of cash returns are lowest, however, and the standard deviation of small stock returns are the highest.

Key Takeaways 

The higher the risk, the higher the expected return (usually).



Historical results are not a guarantee of future performance! (We realize we’re repeating ourselves, but we want to underscore this very crucial fact.)

Answers to Exercises 1. International stocks in this time period had a higher standard deviation (more risk) than large U.S. stocks, but a lower return. So it seems that either large U.S. stocks outperformed during this period, or international stocks underperformed.

Section 6. The Capital Asset Pricing Model (CAPM)   

Explain the difference between market risk and firm-specific risk.

Calculate a portfolio’s beta from its components.

Calculate an asset’s expected return using CAPM.

Section Outline 

Firm-specific risk can be “diversified away.”



Market risk can’t.

© 2019 FlatWorld



Under a portfolio view, then, the measure of risk for an asset is the level of market risk, or beta.

Key Takeaways 

Firm-specific risk can be diversified away, but market risk can’t.



The risk premium of assets should be proportional to their betas.



The beta of a portfolio is the average (weighted mean) of the betas of its components.

Key Terms 

Market risk: Minimum amount of risk that must be borne by those investing in stocks due to factors that affect the entire market. Also called systematic risk or non-diversifiable risk.



Firm-specific risk: The additional risk that any stock has above its market risk, that encompasses all factors that would affect the company’s stock price, but not the market in general. Also called unsystematic, diversifiable, or unique risk.



Risk premium: The expected return in excess of the risk free rate.



Beta: The ratio of a company’s risk premium versus the market’s risk premium.

Answers to Exercises 1. a. Firm-specific b. Market c. Firm-specific 2. Insofar as the price of oil impacts many industries (airlines, transportation, utilities, etc.), it is a large market factor. But if a company with a large exposure to the price of oil chose not to hedge that risk, than it would have a firm-specific risk relative to the other companies that did.

3. 1.01 is the weighted average of the betas.

4. 4%+0.6*5%=7.00%

© 2019 FlatWorld

Section 7. The Bigger Picture  

Explain how risk and return play a role in financial management.

Describe some ethical considerations regarding risk and return.

Section Outline 

It is critical to disclose the actual risk of an investment.

Key Takeaways 

Risk and return play a key part in determining a company’s cost of capital.



Misrepresenting risk is potentially as damaging as misrepresenting return!

Answers to Exercises 1. An older person, especially one on a fixed income, might not be able to bear the risk of such an investment. Often investors in retirement are more interested in security than high returns. Younger investors can offset investment losses by retiring later or working harder to earn more to compensate, but these options aren’t available to someone in retirement, generally.

Section 8. End-of-Chapter Problems Answers to Exercises 1. Yes! Risk aversion means that a person will select less risk over more risk, _all else equal_, and demanding a higher return for higher levels of risk. Her behavior fits these conditions. © 2019 FlatWorld

2. $15,000 3. $17,000 4. Assuming the first sentence was for the values at the beginning of the year, and the last sentence is for the values at the end of the year: a. What was the rate of return on each stock? Stock A: [($3 cash plus $22 ending value)-$20 beginning value]/$20 = $5/$20 = 25%; Stock B: [($4 cash plus $31 ending value)-$30 beginning value]/$30 = $5/$30 = 16.67% b. If we believe past results are the best indication of future performance, then Stock A is expected to average 25% and Stock B 16.67%. c. If the investments are equally risky and they are expected to have similar returns in the future, then a risk adverse investor should select Stock A. 5. a. J, because it has the least relative risk for the same returns. b. Any of them would appeal to someone risk neutral, since they all have the same return. c. L, because it has the most relative risk for the same returns.

6. The expected return of this portfolio is the weighted average of the returns: 10.8%. We cannot determine the expected standard deviation because we don’t know how the assets are correlated with each other (we do know that the maximum expected standard deviation would be 5.4%, which would be if all the assets were perfectly positively correlated, but any lower correlation would lower the standard deviation).

7. a. 8.075% b. Not necessarily. For example, if the composition of the portfolio changes, we would expect the standard deviation to change. c. No. Standard deviation is one measure of risk, but there are other risks to consider.

8. a. Trucks: 0.286; Steamrollers: 0.364; Pavers: 0.333 b. Strictly trying to minimize risk, Pavers is the best, as it has the lowest standard deviation.

9. a. Cookies b. Cupcakes: 0.231; Muffins: 0.221; Scones: 0.333; Cookies: 0.455; If they want to minimize their risk per unit of expected return, muffins are the best as they have the lowest coefficient of variation.

10. a. 0.97 b. 3%+0.97*(4%)=6.88% 11. First find the market risk premium: 10%=2%+1.2*MRP; MRP=6.67%. Then find the second stock: 2%+0.8*MRP=2%+0.8*6.67%=7.34% 12. A portfolio with a beta of 1.0 can certainly have a different standard deviation than the market; just consider a portfolio with 100% invested in one stock with a beta of 1.0. This © 2019 FlatWorld

portfolio will also have all of the firm-specific risk of this stock (since there is no diversification), so we would expect its standard deviation to be higher than that of the overall market. Also, because of firm-specific risk, a stock with a lower beta can have a higher expected standard deviation than a stock with a higher beta.

© 2019 FlatWorld

Chapter 11 Cost of Capital What is the Cost of Capital?  Each dollar a company raises has a cost associated with it, which is equal to the return investors require of their investment.

Section 1. Cost of Capital Overview 

Define the cost of capital.



Identify the costs associated with the costs of capital such as flotation, administrative, and underwriting.

Section Outline 

The cost of capital is the rate of return investors require.



When a firm raises funds, they also face flotation, administrative, and underwriting costs.

Key Takeaways 

The cost of capital is the return a company must earn on its investment projects to maintain its market value.



Flotation costs are the costs of issuing a security.



The components of the cost of capital are 1) debt, 2) preferred stock, and 3) common stock.

Key Terms

© 2019 FlatWorld



Cost of capital: The rate of return a firm must supply to investors.



Flotation costs: Cost of issuing and selling a security.



Administrative costs: Any additional costs such as legal, accounting or printing.



Underwriting costs: Payments to the investment banker for issuing the security.

Answers to Exercises 1. Flotation costs are the costs associated with issuing and selling a security, typically including administrative and underwriting costs.

2. Administrative costs are expenses incurred by the issuer of the security including legal, accounting, printing, etc.

3. Underwriting costs include payments to the investment banker for issuing the security.

Section 2. Cost of Debt 

Understand the components of the cost of debt.



Identify the tax implications of debt.



Explain how debt plays into the weighted average cost of capital.

Section Outline 

The cost of debt is usually found by looking at the after-tax rate of a new issue of debt, since firms can deduct interest costs from their taxable income.

Key Takeaways 

The debt component has important considerations.



Tax considerations are important as interest payments are tax deductible.

© 2019 FlatWorld



We can estimate the cost of debt either by looking at the market or by looking at our historical debt issuances.

Key Terms  

Marginal debt cost: The cost for the next issue of debt.

Historical debt cost: The cost for debt the company issued in the past.

Answers to Exercises

1. Before tax cost would be 11%. If they are allowed to expense interest payments, .11*(1-.21)=0.0869=8.69% is the after-tax cost.

2. Before tax cost would be 6%. If they are allowed to expense interest payments, .06*(1-.21)=0.0474=4.74% is the after-tax cost.

Section 3. Cost of Preferred Stock  

Understand the components of preferred stock.

Explain how preferred stock is a part of the weighted average cost of capital.

Section Outline  The cost of preferred stock is the dividend payment divided by the market price.

Key Takeaways 

Preferred stock is a hybrid security—it’s both debt and equity.



Preferred stock return is calculated as its dividend divided by its price.

© 2019 FlatWorld

Answers to Exercises 1. 7.80/100=7.80% 2. Since dividends paid on preferred shares are not an expense for tax purposes, they don’t have an offsetting savings in taxes.

Section 4. Cost of Common Stock  

Understand the components of common stock.

Explain how common stock is a part of the weighted average cost of capital.

Section Outline 

The cost of common stock is found by using either the dividend growth model, the CAPM, or the “D+RP” method. Each has its own strengths and weaknesses.

Key Takeaways 

The cost of common stock can be calculated using either the constant growth model or using CAPM.



The cost of using retained earnings is assumed to be the same as r s.

Key Terms 

Coefficient of variation: The ratio of the standard deviation to the mean.

Answers to Exercises

© 2019 FlatWorld

1. An expected return on market below the risk free rate would be very unusual (and wouldn’t make sense if investors are risk averse). The problem, as written, gives an answer of: .05+1.4*(.04-.05)= 3.6%! If the market rate (Rm) is meant to be 14%, then the answer is: .05+1.4*(.14-.05)= 17.6% 2. $5/$35 + .02 = 0.1629 = 16.29%

Section 5. Weighted Average Cost of Capital (WACC)  

Compile the WACC equation.

Solve for WACC.

Section Outline 

The WACC is the average cost of capital for equity and bond holders, weighted by the respective percentages of usage.



The weights used are typically the total market value of each component divided by the combined value.

Key Takeaways 

The Weighted Average Cost of Capital is the component returns multiplied by their respective weights.

Key Terms 

Weighted average cost of capital (WACC): The average of the returns required by equity holders and debt holders, weighted by the company’s relative usage of each.

Answers to Exercises © 2019 FlatWorld

1. Assuming interest expense is tax deductible: WACC=.40*.10*(1-.21)+.50*.06+.10*.04 = .0656 = 6.56% 2. Assuming interest expense is tax deductible: WACC=.35*.045*(1-.21)+.45*.055+.20*.07 = .0512 = 5.12%

Section 6. WACC and Investment Decisions   

Explain how WACC plays into investment decisions.

Avoid common mistakes with WACC. Distinguish between what the firm can and cannot control.

Section Outline 

When calculating the WACC, market or current values are better to use than historical or accounting measures.



Firms can’t control market conditions or taxes.



Firms can control capital structure, dividend policy and investment policy.



Riskier projects should yield a return greater than the WACC while relatively safe projects may earn less than the WACC.

Key Takeaways 

A correctly calculated WACC needs to be used properly. o Avoid common mistakes of using historical and book values. o Be concerned with those items a firm can control, such as capital structure, dividend policy, and investment policy.

Answers to Exercises © 2019 FlatWorld

1. Some factors that the firm can control: capital structure, dividend policy, investment policy, etc. Some factors that the firm cannot control: State of financial markets and market conditions (e.g. the risk-free rate), investors’ risk aversion, taxes, etc.

2. If we don’t have access to accurate market rates, historical rates might be our best proxy.

3. Not really. Especially for equity, book values don’t really reflect the current value of the capital. Even if market values aren’t available (e.g. a private company), usually an estimate of market value will be superior to book values.

Section 7. The Bigger Picture  

Explain how WACC fits into the larger picture of finance.

Discuss the ethics of WACC.

Section Outline 

Beware of applying the WACC to all projects. Setting rules for divisions or firms before projects are evaluated may be prudent.

Key Takeaways 

WACC is central to proper discounting for projects.



Since WACC does potentially leave some room for interpretation, setting firm or division wide rules for WACC before projects are considered can help prevent managers from “tipping the scales”.

Answers to Exercises 1. Non-profits also have limited capital, and need to allocate it to the projects that produce the most value. While they may prioritize something other than maximizing return, they still need to be aware of the cost of their capital allocations.

2. There is usually uncertainty surrounding any decision, but we should gauge our impartiality when it comes to our friend. If we can bring in an impartial advisor (either internally or externally), we could have better assurance that whatever decision we made © 2019 FlatWorld

wasn’t unduly influenced by our friendship. Of note: when the range of possible outcomes is very tightly clustered around the threshold value of 10%, there is a question of how sensitive this project really is to the WACC; if it isn’t very sensitive, it might not actually matter that much in practical terms.

Section 8. End-of-Chapter Problems

Answers to Exercises 1.

2.

3.

4.

11.95% 12.35% .13=.35*x+.60*.15+.05*.10 Solve for x. x=.10=10% Assuming sold at par and annual coupon. Received price=100-1=99 PV=-99,000; FV=100,000; PMT=10,000; NPER=20; solve for RATE. YTM=10.12% 5. 10% div. on a par value of $40= $4 per year. $4/($40-$3)=0.1081=10.81% 6. $3/$50+.02=0.08=8% 7. 6.37% 8. Return on stock: 3%+6%=9%; Return on debt: YTM=4.22% (assuming annual coupon); WACC=6.17% 9. Return on stock: 4%+1.3*5%=10.50%; Weight of debt: $30/$80 = 37.5%; Weight of stock: $50/$80 = 62.5%; WACC=8.34% 10. (Assuming a par of $100 for the preferred stock) Return on preferred stock: $4/$60 = 6.67%; Return on common stock: $1*(1.05)/$40 + .05 = 7.63%; Weight of debt: $30/$105=28.6%; Weight of stock: $70/$105=66.7%; Weight of preferred: $5/$105=4.8%; WACC=6.30% 11. YTM of debt (assuming annual coupon): 5.57%; Return of stock: 4%+0.8*5%=8.00%; value of stock: 2 million shares * $25 = $50 million; Value of debt: $20 million * .9945 = $19.89 million; Weight of debt: $19.89/$69.89 = 28.5%; Weight of stock: $50/$69.89=71.5%; WACC=6.98%

© 2019 FlatWorld

Chapter 12 Capital Budgeting Decision Making Which Project(s) Should We Undertake?  Capital budgeting techniques help firms evaluate projects based on financial data.

Section 1. Introduction to Capital Budgeting Techniques 

Explain the difference between independent and mutually exclusive projects.



Apply the ideas of capital budgeting techniques to different projects.

Section Outline 

If an independent project satisfies the investment criteria then it should be selected.



Among the mutually exclusive projects, onle the best should be selected.

Key Takeaways 

Capital budgeting techniques help us determine which project to undertake. First, we need to determine the relevant cash flows and whether or not the projects are independent or mutually exclusive. o Capital budgeting techniques are a series of tools to help us determine which projects to undertake. o Only the best of mutually exclusive projects should be selected. o All projects that meet the minimum criteria should be selected if the projects are independent.

© 2019 FlatWorld

Key Terms 

Capital rationing: When a firm has limited funds to dedicate to capital projects, and projects compete for these limited funds.

 

Mutually exclusive projects: A decision where only one project can be selected from a set of projects (usually by making the other options unnecessary).



Independent projects: A decision where the cash flows of one project are not influenced by the selection of other projects.

Answers to Exercises 1. Most likely mutually exclusive, since it usually wouldn’t make sense to repair a machine if you immediately intend to replace it.

2. Most likely independent, since you could enter multiple markets.

Section 2. Payback Period 

Explain Payback Period.



Calculate payback period for a project.

Section Outline 

The payback period is an intentionally simple way of examining a project by finding out how long the initial investment should be recouped.

Key Takeaways © 2019 FlatWorld



Payback period is a quick and easy way to determine how long until we get our money back.



Payback period is a quick and easy calculation, but needs reinforcement from other capital budgeting decision methods when evaluating complex projects.



Payback period calculates the number of whole years, plus the partial year until we are paid back.

Key Terms 

Payback period: The amount of time until our initial investment is recovered.

Answers to Exercises 1. a. 4.2 years b. 4.0 years 2. It ignores time value of money, as well as any cash flows beyond the payback period.

Section 3. Net Present Value   

Define and calculate Net Present Value.

Apply the accept/reject decision rule of NPV. Explain the limitations of Net Present Value.

Section Outline 

NPV is the best way to evaluate a project even though it may not be the most intuitive.



For independent projects, accept if NPV>0.



For mutually exclusive projects, choose the project with the higher NPV. © 2019 FlatWorld

Key Takeaways 

Net Present Value is the most important tool in capital budgeting decision making. It projects the financial value of the project for the company. o Net Present Value is the discounted value of all cash flows. o It is considered to be the best single criterion. o Positive NPV adds value to a company. o Accept any project with positive NPV for independent projects. o Accept the highest NPV project from mutually exclusive projects.

Key Terms 

Net present value (NPV): Discounting all of the cash flows for an investment to the present, adding inflows and subtracting outflows.

Answers to Exercises 1. a. $20,091.56 b. $47,101.63 c. $23,036.63 2. Only B if they are mutually exclusive, as it has the highest NPV. 3. All three if they are independent, as they all have positive NPVs.

Section 4. Internal Rate of Return   

Define and calculate the internal rate of return (IRR).

Apply the accept/reject decision rule for IRR. Explain the limitations of IRR

Section Outline © 2019 FlatWorld



The IRR gives us the rate of return for a project – assuming all cash flows can be invested at that rate.



The IRR should be avoided for non-normal projects.



For independent projects, if the IRR>WACC, accept the project.



For mutually exclusive projects, pick the project with the higher IRR.

Key Takeaways 

IRR is another method of capital budgeting techniques. We prefer NPV to IRR because of IRR’s potential shortfalls. o IRR is defined as the discount rate where NPV=0. o IRR should never be used if cash flows aren’t ordinary, or if the projects are mutually exclusive.

Key Terms 

Internal rate of return (IRR): The discount rate where the NPV of an investment equals zero.

Answers to Exercises 1. a. 23.38% b. 27.49% c. 60.74% 2. Project C. 3. All three if they are independent.

Section 5. Other Methods   

Evaluate some other methods to evaluating capital budgeting.

Calculate Profitability Index.

Discuss MIRR. © 2019 FlatWorld

Section Outline 

The Profitability Index compares the present value of the cash flows to be received to the initial cost of the project.



The MIRR addresses one of IRR’s weaknesses by discounting all cash flows received at the rate at which they would be reinvested.

Key Takeaways 

Other methods exist to evaluate projects. We learned Profitability Index and MIRR. o Profitability index is bang for your buck. o MIRR assumes a different reinvestment rate than IRR.

Key Terms 

Profitability index (PI): Present value return per dollar of investment.



Modified internal rate of return (MIRR): Internal rate of return assuming that the funds earned cannot be reinvested at IRR.

Answers to Exercises 1. a. 1.20 b. 1.24 c. 1.92 2. All MIRRs are lower, compared to IRR, due to the lower investment rate: a. 17.52% © 2019 FlatWorld

b. 18.28% c. 37.46%

Section 6. Comparing Projects with Unequal Lives  

Explain the difficulty in choosing between mutually exclusive projects with unequal lives.

Calculate the equivalent annual annuity (EAA) of a project and use it evaluate which project is superior.

Section Outline 

If we are comparing two projects with unequal lives we must account for this.



One way to do this is by comparing the annual payments the projects generate using the length and NPV of the projects.

Key Takeaways 

If projects are independent or not repeatable, the impact of differing life is irrelevant.



If the projects are mutually exclusive and repeatable, then the impact of the differing life must be accounted for by comparing their EAA.

Answers to Exercises 1. a. NPV=$89,539.34; EAA=$23,620.25 b. NPV=$105,921.73; EAA=$33,415.21 c. NPV=$9,710.74; EAA=$3,904.83 2. Project B, as it has the highest EAA.

© 2019 FlatWorld

Section 7. Approaches for Dealing with Risk   

Explain risk in capital budgeting.

Describe and implement scenario analysis.

Describe and implement sensitivity analysis.

Section Outline 

Sensitivity analysis examines how much an input can impact the NPV if it is changed.



Scenario analysis examines the impact worst and best case outcomes can impact the NPV.



When making budget decisions, the riskiness of the project should be examined when planning and applying the cost of capital for the project.

Key Takeaways 

Examining different scenarios, the sensitivity of the project to certain inputs, or the range of outcomes can help us deal with risk in budgeting analysis.

Key Terms   

Sensitivity analysis: Indicates how much NPV will change if we change one particular variable.

Scenario analysis: Uses several possible scenarios to determine the range of possible NPV outcomes.

NPV range: The difference between the best-case scenario and the worst-case scenario NPV.

Answers to Exercises © 2019 FlatWorld

1. At 10%, the NPV is $89,539.34 and at 12%, the NPV is $80,238.81; thus the NPV drops $9,300.53 for a 2% increase in the discount rate.

2. At 9% with $75k/year for five years, the NPV=$191,723.84

Section 8. The Bigger Picture  

Explain how capital budgeting decisions fit into the larger picture of corporate finance.

Evaluate the ethical implication of capital budgeting decisions.

Section Outline 

Managers should examine the impact budgeting decisions have on stakeholders.

Key Takeaways 

Making decisions is ultimately what everyone in business does. These tools allow us to properly factor in financial value to make decisions.



When making decisions, we need the numbers, but we also need to look beyond the numbers.

Answers to Exercises 1. Answers may include: Loss of reputation of the company should be a factor; potential loss of human life/injuries; should customers at least be informed so they can have the issue examined/fixed.

2. Answer may vary. Mandating that all cars have extreme safety features at additional costs does cause an opportunity cost. Finding the proper balance will often depend upon the resources available to the customer, so many will opt for letting the customer decide how much they are willing to pay, as long as they have enough information to make the decision. But, then again, some customers choose to not wear seat belts…. © 2019 FlatWorld

Section 9. End-of-Chapter Exercises Answers to Exercises

1. a. 3.33 years b. 7.71% c. No, because the IRR is less than the hurdle rate (and the cash flows are normal).

2. The low resistance tires cost $100 more: a. 2 years b. Yes. The NPV is positive at $24.34 c. Since the NPV is $24.34, if the price of the tires rose above $424.34, the answer would change to “No”. d. 13.38% (IRR=23.38% - the 10% hurdle rate) e. .40*$20+.60*$50=$38 expected savings per year. Now the NPV = -$5.50 so the tires shouldn’t be purchased.

3. Using EAA, since buying shoes is repeatable and they have unequal lives. The cheaper shoes have an EAA of -$132 and the premium shoes have an EAA of -$120.17. The premium shoes have the higher (less negative) EAA, and are thus a better deal.

4. a. 8.21% b. 7.59% c. Both, since they both have IRRs higher than the WACC (and the cash flows are normal). d. Project B, since it has a higher NPV. The IRR is misleading in this case, because of the difference in the size of the initial investment!

5. Assumes all payments are after-tax: a. At 50% chance of success, the expected value of the receipt in year 10 is $500,000. The NPV is $81,845.96; the project should be undertaken since the NPV is positive. b. At 80% chance of success, the expected value of the receipt in year 10 is $800,000. The NPV is a $252,074.02; the project should be undertaken since the NPV is positive.

© 2019 FlatWorld

Chapter 13 Capital Budgeting Cash Flows The Devil is in the Details  When examining a project it is important to examine the cash flows necessary for such an evaluation, and how to calculate these necessary flows.

Section 1. Which Cash Flows Should I Include? 

Explain the concept of incremental cash flows and identify three common special cases.

Identify which cash flows need to be considered when preparing a capital budgeting decision.

Section Outline 

When evaluating a project, only the cash flows occurring because of the project should be included.



These include cash flows foregone as well as cash flows generated; it does not include cash flows which have already occurred or which will occur regardless of the project.

Key Takeaways 

Only incremental cash flows should be considered when evaluating a project.



Opportunity costs should always be included and sunk costs excluded.



Cannibalization should only factor into decision making if the existing product would have kept its value without the new project.

© 2019 FlatWorld

Key Terms    

Sunk cost: A cost that has already been realized and therefore is irrelevant in investment decision making.

Incremental cash flows: Cash flows or consequences that change depending upon our decision to fund the project.

Opportunity cost: Cash flows that would have been received had the project not occurred.

Cannibalization: A new product or service lowering the value of an existing product or service.

Answers to Exercises 1. Yes, since we presumably wouldn’t need the vehicle if we didn’t add home delivery.

2. We would include the loss of $50/month rental income, since we could no longer loan the vehicle to our brother. We would not include the $5,000 purchase price, since it would be a sunk cost; that money is spent regardless of our decision to add delivery.

3. If our take-out sales will suffer, we probably want to include those lost sales (cannibalization). If the local competition adding home delivery, however, would cause our take-out sales to drop regardless, then we shouldn’t include those lost sales.

Section 2. Capital Spending and Salvage Value 

Identify the initial capital expenditure for a project.



Calculate the after tax salvage for a piece of equipment.

Section Outline 

To start, the initial investment is the cost basis for new equipment minus after tax salvage of old equipment.



Over the life of the project the cost basis is used to calculate depreciation, which is a noncash expense ultimately lowering the tax bill. © 2019 FlatWorld



At the end of the project the after tax salvage value can be viewed as a cash inflow.

Key Takeaways 

The required initial investment includes the cost basis of any new machines purchased less after tax salvage on liquidated assets.



Don’t confuse cost basis with book value! The cost basis of an asset typically doesn’t change over time for our purposes, but the book value decreases by the depreciation amount each year.



Likewise, the book value of an asset does not necessarily have any correlation with the actual value of the asset; it is solely a number determined by following the depreciation schedule.



If an asset is sold later in the project, its after tax salvage must be included as a change in capital spending. If an asset is being sold earlier than it otherwise would have because of the project’s acceptance, then the earlier ATS reduces capital spending, but the cash outflow from the later time period when it was originally scheduled to be sold, effectively increases capital spending for that year.

Key Terms     

Cost basis: The total cost of a capital purchase, including installation and delivery fees or other costs necessary to bring the asset into operation.

Depreciation: A non-cash expense (that is, not an actual cash flow) due to the aging of assets, included for the sake of reducing taxes.

Salvage value: The cash flow from the sale of an older asset.

After tax salvage (ATS) value: The cash flow from the sale of an older asset, adjust for any tax implications.

Book value: The accounting value of an asset calculated by subtracting the accumulated depreciation from the asset’s cost basis.

Answers to Exercises 1. Depreciation is $44,625; 58,675; and 41,900 in years 1, 2, and 3, respectively. The ending book values are $205,375; 146,700; and 104,800; respectively. © 2019 FlatWorld

2. $18,000 would be the depreciation in year 3 of a 5 year MACRS class with a cost basis of $100,000. 5 year straight line depreciation would be $100,000/5= $20,000 each year. So MACRS is $2,000 less depreciation in year 3.

3. $110,000 4. After tax salvage will be $20,000 - .21 * (20,000 – 80,000) = $32,600. Note that there is a tax benefit since the machine is being sold at a loss.

Section 3. Operating Cash Flows  

Explain the effect of depreciation on operating cash flows.

Calculate the operating cash flows for each year of a project.

Section Outline 

Depreciation acts as an expense when calculating taxable income.



However, when calculating operating cash flows, one must recognize it is not an actual expense.

Key Takeaways 

Depreciation affects taxes paid, so even though depreciation is a non-cash expense, it indirectly causes an incremental cash flow.



Creating a pro-forma income statement for each year of the project’s operation is a good way to compute the proper operating cash flows.

Key Terms 

Operating cash flows (OCF): The net cash generated from the project in each year from operations.



Pro-forma income statement: Similar to a full income statement, but includes only items that cause incremental cash flows due to the operations of the project. © 2019 FlatWorld

Answers to Exercises 1. Taxes are really a cash flow, whereas deprecation is itself not a tax flow, but can affect taxes.

2. Sales – Op. Costs – Depreciation = EBIT of $100,000; less 21% taxes for NOPAT of $79,000; add back depreciation for OCF = $279,000 (Note: Interest expense is _not_ used in the calculation) 3. Assuming a 21% tax rate: Year 1: COGS lower by $10,000 = Gr. Profit higher by 10,000; less depreciation makes EBIT higher by 9,000; less tax for NOPAT = $7,110; add depreciation for OCF=$8,110 Year 2: COGS lower by $10,000 = Gr. Profit higher by 10,000; less depreciation makes EBIT higher by 8,800; less tax for NOPAT = $6,952; add depreciation for OCF=$8,152

Section 4. Changes in Net Working Capital 

Calculate the effect of changes in the levels of working capital on a capital budgeting decision.

Section Outline 

If a project causes the amount of cash needed to increase, this should be viewed as a cash outflow because it cannot be used for other purposes.



Only changes in NWC should be included.

Key Takeaways 

Only the change in net working capital is included in each year.



Change in net working capital over the life of the project should be zero, because any additions up front will be released when the project is terminated (or vice-versa).

Key Terms © 2019 FlatWorld



Net working capital (NWC): Cash tied up in current asset and current liability accounts from non-financing decisions.

Answers to Exercises 1. 12+16-18 = 10 so NWC increases by $10 (depreciation not used)

Section 5. Making the Investment Decision  

Explain the difference between expansion and replacement projects.

Calculate total cash flows for each year of a project.

Section Outline 

This section entails working through a comprehensive example to calculate the inputs to Free Cash Flow, Free Cash Flow itself, and then the decision regarding the project.

Key Takeaways 

Replacement projects need to consider the differences in cash flows between the old asset and the new, including sale of the old machine now and the lack of selling it in the future.



FCF = OCF – CS – Change in NWC



Once this is determined for each year, use an appropriate decision-making technique such as NPV or IRR.

Answers to Exercises 1. Assuming 25% growth in revenue each year: © 2019 FlatWorld

Revenue Expenses Depreciation EBIT Taxes NOPAT Add Dep. OCF

$ $ $ $ $ $ $ $

35,000.00 26,250.00 7,140.00 1,610.00 338.10 1,271.90 7,140.00 8,411.90

$ 43,750.00 $ 32,812.50 $ 9,388.00 $ 1,549.50 $ 325.40 $ 1,224.11 $ 9,388.00 $ 10,612.11

$ 54,687.50 $ 41,015.63 $ 6,704.00 $ 6,967.88 $ 1,463.25 $ 5,504.62 $ 6,704.00 $ 12,208.62

Section 6. The Bigger Picture  

Explain how details of cash flows fit into the decision making process.

Discuss ethical implications of the specifics of cash flows.

Section Outline 

Managers should examine the impact budgeting decisions have on stakeholders.



Managers should objectively evaluate the project regardless of the impact acceptance or rejection may have on them personally.

Key Takeaways 

Small details can have a large impact on the final investment decision.



Though we focus on FCF, other stakeholder concerns should not be dismissed without adequate consideration.

Answers to Exercises 1. Employee stakeholders might prefer Sofia not be fired (particularly Sofia, but also the morale of other employees might drop if they are also worried about being replaced

© 2019 FlatWorld

someday). Customer stakeholders prefer a human to a computer. All stakeholders, but primarily investors, care about the financial benefits.

Section 7. End-of-Chapter Problems Answers to Exercises

1. Typically we ignore them, since they won’t change based upon our choice to do the project or not; we only want to consider incremental costs.

2. Only include cash flows that change based upon our decision to do the project.

3. a. Include b. Include (opportunity cost) c. Do not include (no opportunity cost) d. Include e. Do not include (no opportunity cost) 4. Probably yes, due to cannibalization. If, however, we think those sales will be lost anyway (due to another company innovating in that space), then no.

5. Accruals are a source of cash (effectively free borrowing). If accruals drop, then that is a use of cash (increased net working capital).

6. Inaccurate cash flows can lead to accepting projects with negative NPVs, decreasing firm value.

7. Accounting income includes non-cash items, such as depreciation, and non-operating items, such as interest expense.

8. a. $500,000 + 20,000 + 5,000 = $525,000 b. 30.00% of $525,000 = $157,500 c. $525,000 * (1-.8437) = $82,057.50 d. 21% * ($100,000-$82,057.50) = $3,767.93 taxes owed e. $100,000-3,767.93 = $96,232.07 9. Gross Profits increase by $25,000. EBIT increases by $4,165. NOPAT increases by $2,707.25. OCF increases by $23,542.25.

10. $75,000; $82,500; $90,750 in years 1, 2, and 3, respectively.

11. 5,000+3,000-(4,000+2,000) = $2,000 increase to NWC. 12. Assuming the remaining book value of the old truck will be depreciated in year 1, and that the new truck will have a salvage value of $10,000 in year 3: a. In year 0, there would be a cash outflow of $30,000 on the new truck less a cash inflow on the after-tax salvage value of the old truck of $4,580. In year 3, there would be a cash inflow of the after-tax salvage of the new truck of $9,601 less © 2019 FlatWorld

what the after-tax salvage on the old truck would have been (since we sold it in year 0) of $790. b. In year 1, the OCF would be $1,365 due to the increased depreciation reducing taxes. Year 2’s OCF is $1,890, and year 3’s OCF is $1,134. c. $2,155; $2,680; and $1,924 in years 1, 2, and 3, respectively. d. Total cash flows in years 0, 1, 2, and 3 are -$25,420; $2,155; $2,680; and $10,735. At 15%, the NPV is -$14,461.19; the new truck should not be purchased, since NPV is negative.

13. Assuming neither projector will have a salvage value after 5 years: a. $18,000 cash outflow, less a cash inflow from selling the old projector of $2,055.23 (which includes a tax benefit from selling at a loss) for a total outflow of -$15,945. b. Years 1-5 respectively: $4,656.23; $4,994.54; $4,630.40; $4,379.79; $4,379.79 c. N.B. There will be a tax benefit in year 5 of $161.03, due to the projector not having a salvage value but still having book value. NPV = $850.04, so the projector should be replaced due to the positive NPV. d. No, because that $5,000 is a sunk cost.

14. Ignoring the word “net” in the sentence, “It can be sold for a price of $40,000 net today.”: a. $13,608 b. 21%*($40,000-13,608)=$5,542.32 owed in taxes (reclaimed depreciation) 15. Assuming the data in Q.14: In year 0, cash outflow of $120,000 less the cash inflow of the after-tax salvage of the existing press of $34,457.68 16. Assuming the data in Q.14: in years 1, 2 and 3, respectively: $43,721.42; $54,180.90; $61,416.00

© 2019 FlatWorld

Chapter 14 Raising Capital and Capital Structure “Give Me a Lever . . .”  The use of leverage can have a powerful effect on a company’s growth. It does not come without risk, however.

Section 1. Life Cycle of a Firm 

Describe potential sources of investment for a growing firm.

Section Outline 

Founders of a company invest their time and effort with little to no compensation initially.



As the firm grows, funding can be obtained from firms specializing in investing in young companies.



Ultimately a firm can tap the public markets in an IPO.

Key Takeaways 

Proprietors and partners supply the capital for very young companies, often in the form of “sweat” equity.



Bank loans and venture capital funding can bring in capital for a growing business.



Public issues of bonds and stocks are the sources of capital for maturing companies.

© 2019 FlatWorld

Key Terms     

Sweat equity: An owner of a company investing in a company by working for long hours with little or no initial compensation.

Venture capital (VC): Firms that seek out investments in young companies, typically matching with investors who are looking for a private equity arrangement.

“A” round financing: The earliest rounds of venture funding.

Mezzanine financing: Venture funding after the earliest round of venture funding; typically a hybrid of debt that can potentially be converted to equity.

Initial public offering (IPO): When shares of a corporation are first registered with the SEC (or other authority, outside the US) and offered for public sale.

Answers to Exercises

1. A bank would be the first place many businesses would look for capital, since a business loan could meet these needs given the scale. If Frances really wants to expand, Venture Capital (VC) funding might be the way to go, but Frances’ dessert might not have the scale that a VC firm would be interested in (it would depend upon specifics). An IPO would probably not be feasible, since the scale is much too small.

Section 2. Leverage 

Explain the effects of leverage on variability of returns.



Define and calculate degree of operating leverage and degree of financial leverage.

Section Outline 

Leverage increases the impact a change in revenue has on our income.



Leverage can come from debt or from fixed costs.

Key Takeaways

© 2019 FlatWorld



Leverage increases potential gains and potential losses.



Operating leverage is caused by large fixed costs.



Financial leverage is caused by interest payments due to debt.

Key Terms   

Leverage: The effect in which debt increases the variability of potential returns.

Operating leverage: Leverage caused by fixed costs of operations.

Financial leverage: Leverage caused by borrowing.

Answers to Exercises

1. Increase leverage, since a larger portion of those revenues will then make it to net income.

2. 3%/2%= 1.5 3. 5%/3%=1.67

Section 3. Capital Structure 

Explain why capital structure decisions influence firm valuation.

Section Outline 

Debt benefits a firm in that the cost of debt is typically lower and it is tax deductible.



As debt increases, a firm is more exposed to bankruptcy however, and so capital structure decisions require a balance of the benefits and pitfalls of debt.

Key Takeaways

© 2019 FlatWorld



Because debt is typically tax deductible, in addition to having a lower cost of capital, there is a benefit to having some debt.



As debt increases, the chance of bankruptcy causes the cost of both debt and equity to rise.

Key Terms  Capital structure: The mix of debt and equity that a firm uses to finance its operations.

Answers to Exercises

1. The debt level would approach 100% if the firm couldn’t go bankrupt, since the cost of debt is usually lower than equity if there are no bankruptcy costs.

Section 4. Choosing the Optimal Capital Structure  

Describe the process of determining the optimal capital structure.

Given costs of capital for various capital structures, determine the optimal capital structure for a firm.

Section Outline 

The optimal capital structure minimizes the cost of capital.



It is found when the next dollar of debt begins to increase the cost of capital.

Key Takeaways 

The optimal capital structure is the one that maximizes firm value by minimizing WACC.

© 2019 FlatWorld

Answers to Exercises

1. 30% debt, since it gives the lowest WACC.

Section 5. The Bigger Picture  

Describe how capital structure decisions can influence firm value.

Explain some ethical consideration surrounding capital structure decisions.

Section Outline 

Managers should examine the impact leverage has on all shareholders.

Managers must not be tempted by disguising leverage in an effort to lower the cost of capital.

Key Takeaways 

Leverage adds risk to a company, so the ethical manager needs to consider what is most appropriate for the all the stakeholders.

Answers to Exercises

1. She has an obligation to the owners as stakeholders to balance the benefits of the increased leverage against the potential costs if the firm has financial stress.

Furthermore, other stakeholders, such as customers, suppliers, and employees, might be adversely affected by financial distress, which might suggest caution, but might also benefit from the added success if more leverage is used. This will require a careful balancing of pros and cons.

© 2019 FlatWorld

Section 6. End-of-Chapter Problems

Answers to Exercises

1. 0% debt and 100% equity has the lowest WACC: cost of after tax cost of % cost of % debt debt debt equity equity WACC 0% 6.40% 4.80% 100% 9.0% 9.00% 10% 6.40% 4.80% 90% 9.8% 9.30% 20% 6.90% 5.18% 80% 10.4% 9.36% 30% 7.70% 5.78% 70% 11.0% 9.43% 40% 8.40% 6.30% 60% 12.5% 10.02% 50% 9.20% 6.90% 50% 14.4% 10.65% 60% 10% 7.50% 40% 16.8% 11.22% 70% 11.50% 8.63% 30% 19.0% 11.74% 80% 13% 9.75% 20% 25.0% 12.80% 90% 18% 13.50% 10% 32.0% 15.35% 100% 25% 18.75% 0% 47.0% 18.75% 1. 30% debt and 70% has the lowest WACC: % debt 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

cost of after tax cost of % cost of debt debt equity equity WACC 5.00% 3.75% 100% 9.0% 9.00% 5.00% 3.75% 90% 9.6% 9.02% 5.50% 4.13% 80% 10.2% 8.99% 6.20% 4.65% 70% 10.8% 8.96% 7.00% 5.25% 60% 11.6% 9.06% 7.80% 5.85% 50% 12.4% 9.13% 9% 6.45% 40% 13.6% 9.31% 9.50% 7.13% 30% 14.8% 9.43% 11% 7.88% 20% 16.0% 9.50% 12% 9.00% 10% 19.0% 10.00% 15% 11.25% 0% 24.0% 11.25%

2. DOL=2.40; DFL = 1.25; DTL = 3.00 old sales COGS

new 1200 600

increase 1400 16.67% 680 13.33% © 2019 FlatWorld

fixed dep ebit interest ebt tax net income

200 100 300 100 200 50

200 100 420 120 300 75

0.00% 0.00% 40.00% 20.00% 50.00% 50.00%

150

225

50.00%

3. DOL=3.67; DFL = 0.75; DTL = 2.75 old sales COGS fixed dep ebit interest ebt tax net income

new 2200 1400 300 200 300 100 200 42

2400 1500 300 200 400 150 250 52.5

increase 9.09% 7.14% 0.00% 0.00% 33.33% 50.00% 25.00% 25.00%

158

197.5

25.00%

4. units

12,000

sales COGS fixed ebit interest ebt tax net income DOL DFL DTL

$ $ $ $ $ $ $ $

13,000

840,000 240,000 400,000 200,000 100,000 100,000 21,000 79,000

$ $ $ $ $ $ $ $

3.00 2.00 6.00 a. $200,000 and $250,000 b. 3.00 c. $79,000 and $118,500 © 2019 FlatWorld

910,000 260,000 400,000 250,000 100,000 150,000 31,500 118,500

% change 8.33%

25.00%

50.00%

d. 2.00 e. 6.00

© 2019 FlatWorld

Chapter 15 Dividend Policy Case Study – To Pay or Not to Pay, That is the Question. 

Stock owners can receive periodic income in the form of dividends. While some may prefer this, others would rather the company keep the funds and invest in the business.



Which is better for the individual? For the firm?

Section 1. Dividend Basics 

Explain cash dividends and stock repurchases.



Describe an appropriate usage of each.

Section Outline Dividends provide income to investors. 

Some investors or funds only invest in firms which pay dividends.

Microsoft and Dividends 

Microsoft famously never paid dividends, instead investing in research and development.



When companies begin paying dividends, it is expected that the dividend payments will continue.



Dividends provide a signal to the market in that the firm is capable of continuing to pay dividends into the future.

Other Methods 

Dividends are declared by the Board of Directors.



Firms may also repurchase shares. A tender offer is an offer to buy shares at a specific price.

Key Takeaways

© 2019 FlatWorld



Dividends are a way to distribute corporate profits to shareholders.



Dividends are declared by the Board of Directors and send a signal to the market.



Stock repurchases are another use of excess cash.

Key Terms     

Dividend: A portion of the company's profits paid back to investors.

Declaration date: The date the dividend is declared by the company's Board of Directors.

Date of record: The date on which all persons who are on record as owning a share of stock will receive the dividend.

Ex-dividend date: This date is the first date on which a stock is sold without the right to receive the current dividend.

Payment date: The actual date the firm pays the dividend to the holders of record.

Answers to Exercises

1. The declaration date is the date the dividend is announced. The date of record is the date on which all persons who are on record as owning a share of stock will eventually receive the dividend. The ex-dividend date is the first date on which a stock is sold without the right to receive the current dividend. The payment date is the actual date the firm pays the dividend to the holders of record. The different dates are necessary so the firm has time to a) determine who are the shareholders of record, and b) pay those shareholders the dividend. The ex-dividend date occurs because trades take two days to settle.

2. Some advantages of dividends include: smaller periodic payments can be made, investors can rely upon a dividend yield. Some advantages of stock repurchases are: the might be tax advantages for those holding the stock, investors might understand if they are not as regular, they might be better when companies have a lot of cash on hand that they want to return to investors.

Section 2. Dividend Policy 

Explain the different strategies for deciding a dividend amount.



Explain if dividends impact corporate value.

© 2019 FlatWorld

Section Outline

Academic view of dividends 

Most academics would agree dividends should be paid after all worthwhile investments have been undertaken.



Modigliani and Miller argued that whether a firm pays a dividend is irrelevant as far as creating firm value.

Common method of paying dividends. 

The more common method of dividends is a stable dividend, where the firm pays the same amount each year, subject to a regular, steady increase if profits allow.

Key Takeaways 

Dividends can either be a residual, constant % of earnings, or a constant amount per share.

Key Terms

     

Residual theory of dividends: When dividends are paid only after all worthwhile projects have been undertaken.

Stable dividend: When the dividend is the same dollar amount each year.

Constant dividend payout ratio: When the dividend is a constant percentage of earnings each year.

Low dividend plus extra policy: The company's annual dividend is always low, but it is supplemented by paying an 'extra' dividend when appropriate.

Dividend yield: Dividend divided by share price.

Dividend irrelevance: Theory that dividends do not impact corporate value.

Answers to Exercises

1. Assuming "a constant dividend payout ratio of 50%": © 2019 FlatWorld

a. 50%*$3,000,000/15,000,000=$0.10 per share for a dividend yield of 0.10/60 = 0.17% b. $1.00/$60 = 1.67%

Section 3. Other Forms of Dividends  

Describe stock splits.

Describe stock dividends.

Section Outline Stock dividend 

A stock dividend is when the dividend payment is made in shares.



Similar to a stock dividend is a stock split, when the number of shares each investor owns, and the share price is adjusted.

Key Takeaways 

Dividends can be paid in other ways than cash. They can be paid as a stock dividend or as a stock split.



A company also will buy back its shares of stock for many different reasons.

Key Terms   

Stock dividend: The dividend payment is made in the form of stock instead of cash.

Stock splits: A company manipulates its share price by increasing the number of shares belonging to each shareholder.

Stock repurchase: When a company buys back its shares of stock.

Answers to Exercises © 2019 FlatWorld

1. A stock split would reduce the price of each traded share, so a company might do one to adjust the trading range of the shares (for example, Apple needed to do one to be considered for inclusion in the DJIA). Similar argument for a stock dividend. Neither costs the company significant cash, unlike a cash dividend.

2. If the company thought the shares were undervalued and had the cash on hand, or if they wanted to adjust the firm’s capital structure, or even to protect against a takeover. Also, repurchases over time tend to cause higher stock prices compared to using the same cash for dividends, so a repurchase could be a deliberate move to raise stock prices over time.

Section 4. The Bigger Picture  

Explain the role of dividends in the economy and differences around the world.

Discuss the ethical considerations of dividends.

Section Outline Dividends can enforce discipline 

If dividends are paid, this can enforce discipline upon the managers as the cash available to them is limited.

Key Takeaways 

Dividend policies vary between companies because of lifecycle of the firm, but this may limit the type and number of investors.



Ethical considerations of dividends include choosing one group over another.

Answers to Exercises

1. The needs of shareholders need to be balanced with the needs of the employees; the particulars of the circumstance would dictate the ethicality of the decision. In the second case, it is making a decision of distributing funds to shareholders now vs. growing the business. Some shareholders

© 2019 FlatWorld

might prefer the cash now, and some might prefer the growth. Likewise, other stakeholders might prefer the growth, so their needs should also be included in the decision.

Section 5. End-of-Chapter Problems

Answers to Exercises

1. A stock repurchase is when a company uses cash to buy back its own stock. Stock splits and stock dividends require no cash, but increase the number of shares outstanding, causing the stock price to adjust to the new float.

2. A payment of a dividend will usually affect the stock price, since the company will have less cash after the dividend is paid. A stable dividend policy is when the dividend is the same dollar amount each year. A constant dividend payout ratio is when the dividend is a constant percentage of earnings each year. A low dividend plus extra policy has the company maintaining a low dividend with an “extra” dividend when appropriate.

3. 1.80*550,000=$990,000 needed. With T+2 settlement, the ex-dividend date will be the trading day before the date of record, so Wednesday, March 31st.

4. A stable payout policy will have a constant dividend, while a constant payout ratio will fluctuate with earnings. A low dividend plus extra policy will usually have a constant dividend, with occasional high payouts.

5. Yes, they can use $2.8-1.3=$1.5 million for dividend payouts.

6. Monday, July 30th (assuming T+2 settlement) is the last day to purchase stock and receive the dividend. Tuesday, July 31st is then the ex-dividend day. On that day, the stock price per share should drop by about $0.75, since purchasers of the stock will no longer get the value of the dividend.

7. 2-for-1: There will be 1,000,000 shares outstanding with a $2 par. None of the other numbers change. 6-for-1: There will be 3,000,000 shares outstanding with a $0.666 par. None of the other numbers change. 1-for-4: There will be 125,000 shares outstanding with a $16 par. None of the other numbers change.

8. a. There will be 750,000 shares outstanding with a $2 par. None of the other numbers change. b. $60 per share c. The firm could use the $8 million in retained earnings. Before the split, this would amount to $16/share. After the split, $10.67/share. d. The firm could use only $4 million. Before the split, this would amount to $8/share.

After the split, $5.33/share. e. A stock split drastically changes the number of shares outstanding, whereas a stock dividend usually has a much smaller effect.

© 2019 FlatWorld

9. a. $0.48; 0.52; 0.56; 0; 0.32; 0.20 b. $1 each year c. The first policy fluctuates much more than the second.

10. A lower stock price would enable the company to purchase the shares more cheaply, but the CFO and CEO both have an ethical obligation to consider the needs of all stakeholders, and to follow the law (attempting to manipulate stock prices is usually illegal).

© 2019 FlatWorld

Chapter 16 Cash and the Cash Conversion Cycle Cash is King 

Firms need to balance the returns which come from investing in assets with the need to keep cash on hand to pay suppliers, employees, and creditors.



During turmoil, liquidity in assets dries up, making it more difficult to convert assets into cash.

Section 1. Financial Planning 

Describe a corporate financial plan.



Distinguish and explain the difference between short-term and long-term plans.

Section Outline There are two components to corporate financial planning: planning for cash flows and planning for profits.   

The first step is cash budget planning (remember cash is king). A good cash budget becomes the foundation for a profit plan.

The second step is planning for profits.

The profit plan involves pro forma statements.

Key Takeaways 

A financial plan is an assessment of a company’s current financial situation and a projection of their future situation.



Short-term plans are 1–2 years and long-term plans are typically 2–10 years.

© 2019 FlatWorld

Key Terms 

Financial plan: An evaluation of a company’s current financial state and a plan for the future.

Answers to Exercises

1. Those who fail to plan, plan to fail. They need a plan to make sure cash is available when it is needed, and to make decisions about the proper actions to take.

2. Both require thinking about cash inflows and outflows, so as to not run out of cash.

Everyone should have a financial plan!

Section 2. Cash Budgets 

Describe a cash budget.



Distinguish and explain the difference between cash inflows and outflows.

Section Outline

Any cash coming in to the firm is an inflow. 

A decrease in an asset results in an increase in cash since presumably the asset is converted into cash.



A profit is an inflow.

Any cash leaving the firm is an outflow. 

An increase in a liability results in an increase in cash.



A loss is an outflow.

© 2019 FlatWorld

Key Takeaways 

Cash management is vital to the health of any company. A cash budget is a vital tool in cash management as it helps with a company’s financial planning, both short-term and long-term.



A cash budget is an important tool in financial planning.



Key in accurate prediction of a cash budget is the sales forecast and any other external or internal variables.



Cash inflows are positive, cash outflows are negative.

Key Terms

 

Cash inflow: A source of cash or an increase in the company’s cash balance.

Cash outflow: A use of cash or a decrease in the company’s cash balance.

Answers to Exercises

1. Sales: usually a cash inflow (although might be cash neutral if the customer buys on credit); Electric Supplier Invoice: outflow; Mortgage: if a payment, an outflow. If taking out a mortgage to make a purchase, an inflow. Payment from customer: inflow 2. Inflows: 50,000+15,000=$65,000 Outflows: 2,000+20,000=$22,000 (depreciation is not a cash expense!). Net inflow of $65,000-22,000=$43,000

Section 3. Net Working Capital Basics  

Identify working capital and why working capital is needed.

Explain different strategies for determining the level of net working capital.

© 2019 FlatWorld

Section Outline Net working capital 

Net working capital is the difference between current assets and current liabilities.



Net working capital is needed to fund the immediate cash needs of the business.

Managing net working capital 

A conservative strategy is funding both seasonal and long-term requirements using longterm financing.

An aggressive strategy funds seasonal requirements with short-term financing.

Key Takeaways 

Working capital is the difference between current assets and current liabilities.



There are different strategies to manage working capital including aggressive and conservative.

Key Terms 

Net working capital: The difference between current assets and current liabilities.

Answers to Exercises

1. $15,000+30,000+20,000-25,000 = $40,000 2. Peak need: $15,000+55,000+45,000-25,000=$90,000, so $50,000 of seasonal funding needed.

3. If short-term borrowing rates rise significantly, it could cost a lot more to borrow. If short-term borrowing rates drop, then the conservative strategy won’t earn as much on marketable securities. Generally, a conservative strategy is better when long-term rates are low relative to short-term rates.

© 2019 FlatWorld

Section 4. Cash Conversion Cycle   

Describe the parts of the cash conversion cycle.

Calculate the cash conversion cycle.

Explain how to manage the cash conversion cycle to manage operating capital.

Section Outline Cash Conversion Cycle 

The cash conversion cycle is divided into three parts: parts: the average payment period, the

average collection period and the average age of inventory. 

The operating cycle is the sum of the inventory conversion period and the receivables conversion period. It is the length of time from the receipt of raw materials to the collection of

payment for the goods sold. o The inventory conversion period is the average time between when raw materials are received and product is sold. o The receivables conversion period is the average time between sale and collection of funds. 

The payables conversion period is the average time between acquiring raw materials and payment for them.



The cash conversion cycle is the difference between the operating cycle and the payables conversion period.

Key Takeaways 

The shorter the cash conversion cycle, the better we are managing our cash flow.

Key Terms 

Cash conversion cycle: The length of time it takes a company to convert purchases of raw materials into cash received.



Operating cycle: The time from the receipt of raw materials until the receipt of cash for the sale of the goods.

© 2019 FlatWorld



Inventory conversion period: The average time between when raw materials are received into inventory and product is sold.



Receivables conversion period: The average time between a sale and collection of the receipt.



Payables conversion period: The average time between acquiring raw materials and payment for them.

Answers to Exercises 1. The inventory conversion period is how long (on average) cash is “tied up” in inventory.

The receivables collection period is how long cash is “tied up” in customer borrowing.

The payables conversion period is how long we take to pay our suppliers.

2. 25.3+19.9-14.7=30.5 days

Section 5. The Bigger Picture   

Managers should be mindful of collection efforts so that they do not alienate customers.

Managers should properly account for bad debts and aged inventory.

Managers should also responsibly grant credit to customers.

Section Outline Cash Conversion Cycle 

The cash conversion cycle is divided into three parts: parts: the average payment period, the

average collection period and the average age of inventory. 

The operating cycle is the sum of the inventory conversion period and the receivables conversion period. It is the length of time from the receipt of raw materials to the collection of

payment for the goods sold. o The inventory conversion period is the average time between when raw materials are received and product is sold. o The receivables conversion period is the average time between sale and collection of funds. 

The payables conversion period is the average time between acquiring raw materials and payment for them. © 2019 FlatWorld



The cash conversion cycle is the difference between the operating cycle and the payables conversion period.

Key Takeaways 

Proper cash management is vital.



Policies regarding cash have the potential to alienate customers. Balance is key in proper cash management.

Answers to Exercises

1. The customer might benefit significantly with more lenient terms, but it might expose the company to more risk if the customer eventually defaults, harming shareholders. Also, more lenient terms might require more funding by our company, causing our costs to rise.

The needs of the stakeholders need to be compared.

Section 6. End-of-Chapter Problems

Answers to Exercises

1. COGS should be $30,600; Revenues should be $40,500; and Purchases should be $13,250.: ICP=$5,600/(30,600/365)=66.8 days; RCP=$3,200/(40,500/365)=28.8 days; PCP=$2,100/(13,250/365)=57.8 days; Operating Cycle = ICP+RCP=66.8+28.8=95.6 days 2. CCC = ICP + RCP – PCP = 66.8+28.8-57.8=37.8 days [timeline] 3. COGS should be $22,200; Revenues should be $34,600; and Purchases should be $25,555.: ICP=$1,500/(22,200/365)= 24.7 days; RCP=$220/(34,600/365)= 2.3 days; PCP=$100/(25,555/365)= 1.4 days; Operating Cycle = ICP+RCP=24.7+2.3=27.0 days 4. CCC = ICP + RCP – PCP = 24.7+2.3-1.4=25.6 days [timeline] 5. Yes! If ICP + RCP is shorter than PCP, then the CCC would be less than zero. This would mean that the company collects cash from the customers _before_ paying it to the suppliers, on average.

6. The cash conversion cycle also factors in the time taken to pay suppliers. © 2019 FlatWorld

7. The longer the cash conversion cycle, the longer money is “tied up” in net working capital, so the more cash will be needed to fund net working capital.

8. Operating cycle=90+45=135 days; Cash Conversion Cycle=90+45-40=95 days; Cash needed: Inventory=90/365*$25 million = $6.16 million; A/R=45/365*$50 million=$6.16 million; A/P=40/365*$10 million=$1.10 million; so total cash needed = $6.16+6.161.10=$11.22 million. Shortening the inventory conversion period, shortening the receivables conversion period, or lengthening the payables conversion period would reduce the cash needed.

9. Inventory turnover = COGS/Inventory, so inventory= $3 million /6 = $0.5 million; inventory conversion period is $0.5 million /($3 million/365)=60.8 days. Operating cycle = 60.8+60 = 120.8 days. Cash conversion cycle=60.8+60-40=80.8 days 10. 40+25-19=46 days

© 2019 FlatWorld

Chapter 17 Current Assets and Current Liabilities Management Brother, Can You Spare a Dime? 

Does our company: o

Have enough cash to get through the month until we receive payment for sale of our goods?

o

Can we afford to hire a new salesperson?

o

How are our short-term investments performing?

Section 1. Inventory Management 

Describe the different types of inventory.



Explain some of the costs that managers need to consider when selecting inventory levels.



Describe different types of inventory management systems.

Section Outline 

The twin goals of inventory are to ensure there is enough inventory available to sustain operations.



Forecasting customer demand is a large part of inventory management. If we could accurately predict exactly what customers would want, we could keep levels of inventory at a bare minimum.

 

Because demand is not perfectly predictable and suppliers may not always be able to deliver raw materials, firms will hold safety stock, or extra inventory.



Two inventory approaches are just-in-time and the ABC method.

© 2019 FlatWorld

Key Takeaways 

Inventory management depends upon trading off the costs from lack of inventory with the costs of holding too much inventory.

Key Terms     

Raw materials: Inputs to production.

Work in progress (WIP): Goods being produced.

Finished goods: Finished goods ready to be sold.

Safety stock: Extra inventory that is held to protect against the costs associated with lack of inventory.

Just-in-time (JIT): Inventory system that brings in raw materials just in time to put into production.

Answers to Exercises 1. Cars are “A”, car parts are “B”, and decals are “C”. Cars might be inventoried daily, parts monthly or yearly, while decals might just be reordered when they run out.

Section 2. Accounts Receivable Management 

Describe the 5 C's of credit.



Explain common credit terms.

Section Outline 

The 5 C’s of credit are character, capacity, capital, collateral and conditions.



Credit terms are terms extended by the company. o The credit period is the time allowed to pay. © 2019 FlatWorld

o The cash discount is a discount offered if paid within a certain number of days.

Key Takeaways 

The 5 C's of credit include character, capacity, capital, collateral and conditions and are a tool to analyze credit worthiness.



Credit terms, period, monitoring and average collections period are all determined by a company as part of their accounts receivable management.

Key Terms

    

Credit score: A statistically derived number based on key variables to determine a company's credit worthiness.

Credit terms: Terms for the sale of goods extended by the company.

Credit period: Length of time allowed for a company to pay.

Cash discount: A discount offered for payment within a certain time period. Typically a percentage deduction from the purchase price.

Answers to Exercises

1. Character, Capacity, Capital, Collateral, and Conditions. Depending upon the amount being lent, companies can explore these do identify the customer’s ability to pay, as well as assessing the risk of the loan.

2. 2/10 net 30 is the common credit term cited in the text. Different industries might have different conventions for what is common.

Section 3. Cash Management and Investing Idle Cash 

Describe when we may have extra cash. © 2019 FlatWorld



Discuss the possible investments for idle cash.

Section Outline 

Financial managers have a good idea of the cash flow required and may keep extra to meet unexpected expenses.



Excess cash is invested in short term Treasury instruments and CDs.

Key Takeaways 

There is an opportunity to invest idle cash to earn a return.



Balancing the investment opportunity with the need for cash for transactions is vital.



Typical investments for excess cash are short-term U.S. securities, CDs and commercial paper.

Key Terms  

Compensating balance: The minimum balance that must be maintained in an account.

Float: Time before a check clears. The difference between the amount listed in the check ledger and the actual amount in the bank.

Answers to Exercises

1. A compensating balance is a minimum balance that must be maintained in an account.

2. Creating a daily budget might help identify idle cash, as would monitoring balances and comparing them to mandated minimums. © 2019 FlatWorld

Section 4. Accounts Payable Management  

Describe different types of trade credit.

Calculate the cost of taking or not taking trade discounts.

Section Outline 

The goal of accounts payable is to pay as late as possible without losing the trade discount or harming the relationship.



Forgoing a trade discount is akin to granting the payee a loan (often at a high rate!).

Key Takeaways 

Current liabilities management includes the management of accounts payable, accruals and secured and unsecured sources of funds.



Trade discounts are a common tool in accounts payable management. Companies should calculate whether or not they should take the trade discount.

Key Terms 

Trade credit: When a firm makes purchases from a supplier on credit.

Answers to Exercises

1. .02/.98 = 2.041%; annualized: 2.041%*365/(45-10)=21.28%; .05/.95=5.26%; annualized: 5.26%*365/50=38.42%; .01/.99=1.01%; annualized: 1.01%*365/35=10.53% © 2019 FlatWorld

2. If the annualized cost of the trade discount is less than the cost of capital, then the company should not take the trade discount (i.e. pay later). If the annualized cost is more, then the company should take the trade discount (i.e. pay earlier and take the discount).

Section 5. Accruals Management  

Describe different types of accruals.

Discuss payment of accruals.

Section Outline 

Firms can use accruals as short-term interest free loan.

Key Takeaways 

Companies have little control over the due dates of their accruals but can still use them to their advantage.

Key Terms 

Accruals: Reoccurring short-term liabilities such as wages and taxes.

Answers to Exercises

1. Wages, Taxes, Social Security Payments, and Employee Withheld Taxes are all examples of accruals. Typically this money is paid on a later date than the expense is incurred, but rarely is interest paid, amounting to an interest-free loan.

Section 6. Short-Term Loans (Unsecured) © 2019 FlatWorld

 

Describe the different types of unsecured funds.

Explain when each type of unsecured funds might be used.

Section Outline



Short-term loans can be accessed more quickly than long-term loans but are riskier due to variable rates.



Commercial paper and a line of credit are examples of short-term loans.

Key Takeaways 

Unsecured sources of funds are commercial paper, lines of credit and bank loans.



Short-term debt is quicker to access but also riskier because of variable interest rates.

Key Terms 

Commercial paper: A form of financing that consists of short-term, unsecured promissory notes issued by firms with good credit.



Line of credit: An informal agreement between a bank and a customer that a certain amount of money is available to the customer over a period of time.



Prime rate: The rate banks charge their best customers.

Answers to Exercises

1. A loan could have multiple payments due, or only one payment, sometimes structured as a discount loan. Lines of credit or commercial paper are other possible ways to borrow funds short-term.

© 2019 FlatWorld

Section 7. Secured Uses of Funds  

Describe the different types of secured financing.

Explain when each type might be appropriate.

Section Outline 

Secured financing is accessed after exhausted its unsecured financing.



Firms may pledge accounts receivable as the collateral held against the financing.

Key Takeaways 

Secured loans are also available as a source of funding for a business.



Accounts receivable and inventory can be used as collateral for a secured loan.

Key Terms 

Secured financing: Financing with a specific asset pledged as collateral.



Commercial finance corporation: A lending institution that makes secured loans to companies, both short and long-term.



Factoring: The selling of accounts receivable at a discount to a finance company.

Answers to Exercises

1. Commercial finance companies are not regulated as banks, and usually offer collateralized loans.

2. Assets, receivables, inventory, etc.

© 2019 FlatWorld

Section 8. The Bigger Picture  

Explain how current asset and current liabilities management fit into the larger picture of financial management.

Describe some ethical considerations of current asset and current liabilities management.

Section Outline 

When managing current assets and liabilities, care must be taken not to damage business relationships.



Unscrupulous managers may falsely report current assets or not properly account for bad debts.

Key Takeaways 

Current assets require financing, and proper management can keep these costs low.



Policies regarding current assets have the potential to alienate customers. Accounting of current assets is a prime target for unscrupulous managers.



Policies regarding current liabilities have the potential to alienate suppliers. Abuse of credit terms is a common practice in current liabilities management.

Answers to Exercises

1. Answers will vary. On the one hand, the supplier could choose to start enforcing the policy if they no longer felt the status quo was appropriate. However, if the company has a strong position of leverage over the supplier, then it might be taking advantage of the stakeholder. Other stakeholders do benefit, however, when the company is able to take the discount; paying sooner or forgoing the discount could worsen the position of these stakeholders.

Section 9. End-of-Chapter Problems

© 2019 FlatWorld

Answers to Exercises

1. (1-.02)*$50,000=$49,000 if they take the discount, $50,000 if they do not. 2/(1002)=2.04%, or 2.04%*365/20=37.24% annualized.

2. a. 1.01%, or 18.43% annualized b. 2.04%, or 24.83% annualized c. 2.045, or 14.90% annualized 3. For all three cases, the discount should be taken, since the cost of giving it up would be more than the 10% cost of borrowing.

4. If non-discount payments could be stretched by 30 days, then the annualized cost of the discount is: a. 7.37% b. 12.41% c. 9.31% The company should then give up the discount for A and C, but still keep it for B. 5. The annualized cost of the discount is 7.37%, so the discount should not be taken, and the money borrowed from the bank at 7% instead.

6. a. 2.04% for 37.24% annualized b. 1.01% for 18.43% annualized c. 1.01% for 10.53% annualized d. 1.01% for 7.37% annualized e. 3.09% for 22.58% annualized 7. Float is the cash available between the time a check is written and the time it is cashed.

Modern electronic systems have very much reduced float, so to use it to your company’s advantage, you should have modern check processing systems to speed up collection.

8. The typical trade-off is that tighter credit for customers usually causes less revenues, since some customers won’t be able to purchase as much, but there will be less bad debt and less cash tied up in receivables.

9. Commercial paper can be sold more easily in capital markets, whereas a line of credit leaves a company beholden to a specific lender’s terms. Commercial paper isn’t a good option for companies with lower credit ratings.

10. Given that there are, at best, errors and, at worst, fraudulent claims on the customer’s application, credit probably shouldn’t be extended without digging further into the application and getting to both the correct data and the cause of the discrepancies. There might even be a legal obligation to say something to regulators.

© 2019 FlatWorld

Chapter 18 International Considerations A Global Marketplace 

While global population continues to climb, technology and innovation have made trade and commerce more connected across nations. o

Where before there was fragmentation based upon national boundaries, we see trade agreements, trade organizations, economic zones, and many other structures that support a multinational approach to business.

o

What is truly domestic? What do you call a car made in Tennessee from parts made in Mexico for a company based in Germany?

Section 1. Multinational Corporations 

Describe a multinational corporation.



Explain the criticisms and support for multinational corporations.

Section Outline  

Multinational corporations have facilities and assets in at least one country other than their home country.

Multinational corporations play a role in globalization.

Key Takeaways 

Multinational corporations are a way for a company to access new markets, gain access to resources and diversify.



Multinationals play a role in globalization.



Critics of multinationals say that they can hurt a developing country’s environment or culture.

© 2019 FlatWorld

Key Terms  

Multinational Corporations (MNC): Corporations with a home country and then facilities and assets in a least one other country.

Globalization: The interconnectedness of markets and people across countries.

Answers to Exercises

1. Access to more customers, suppliers, employees, etc.

2. Many service companies are multinational, esp. since employees can be close to customers around the world.

3. Benefits include a larger market for products and raw materials, a larger pool of human capital, greater access to resources, etc. Drawbacks can include dealing with many sets of laws, many different governmental bodies, different currencies, a different set of global risks, etc.

4. Globalization can mean that a small, local business now has competitors entering its region from all over the world! On the positive side, it might also have a wider range of suppliers to purchase from.

Section 2. Taxes and Reporting 

Describe the different tax considerations for multinational corporations.



Describe the different tax reporting requirements for multinational corporations.

Section Outline 

Multinational corporations must satisfy tax burdens in all countries in which they do business.

Key Takeaways 

MNCs follow the basic principles of managerial finance with a few exceptions. © 2019 FlatWorld



MNCs have to file financial reports and pay taxes in the countries where they do business.

Answers to Exercises

1. It probably has to file reports in both countries, and is probably responsible for some taxes in both countries.

Section 3. Exchange Rates   

Explain exchange rates.

Translate currencies given an exchange rate.

Describe exchange rate risk.

Section Outline



The exchange rate is the rate at which the counter currency can be exchanged for the base currency.



Exchange rate risk is the risk that the exchange rate changes may negatively impact a firm.

Key Takeaways 

An exchange rate is always quoted in units of counter currency (the currency being changed to) per 1 unit of base currency (the currency being changed from).



To swap the counter currency and the base currency, take the reciprocal (1/n) of the quoted exchange rate.

Key Terms © 2019 FlatWorld

    

Exchange rate: The amount of one currency (called the counter currency) that can be exchanged for one unit of another (called the base currency).

Counter currency: In an exchange rate, the currency that is being changed to.

Base currency: In an exchange rate, the currency that is being changed from. Always presumed to be 1 unit in a quoted exchange rate.

Exchange Rate Risk: Changes in exchange rates which can have negative impact on company’s financials and profitability.

Answers to Exercises

1. Pounds Sterling will be the base currency.

2. a. New Zealand Dollar (NZD) b. United States Dollar (USD) c. The United States Dollar, since only 0.801 USD is used to buy 1 NZD d. $2403 in USD e. $3,745.32 in NZD

Section 4. Other Risk Factors   

Explain and give examples of economic risk.

Explain and give examples of political risk.

Explain and give examples of cultural risk.

Section Outline Besides exchange rate risk, other risk exists when operating globally. 

Ecomonic risk stems from macroeconomic factors.

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Political risk stems from governmental influence/actions.

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Cultural risk emanates from differences in cultural norms.

Key Takeaways © 2019 FlatWorld

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In addition to exchange rate risk, economic, political, and cultural risks are the chief risks (but not all) multinationals face.

Key Terms 

Economic risk: All risks that stem from macroeconomic factors.

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Political risk: All risks that stem from the controlling government of the countries in which the company operates.

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Cultural risk: All risks that stem from differences in culture between the domestic and foreign operations.

Answers to Exercises

1. Political risk 2. Cultural risk 3. This is arguably both a political risk, because it is currently allowed by government regulators, and cultural risk, since it is a tolerated practice in the country.

Section 5. Investment Decisions   

Understand that capital budgeting for multinational requires an analysis of exchange rates.

Describe transfer pricing as involving allocating costs and profits between corporate and subsidiaries.

Calculate projections that include an analysis of international risk factor.

Section Outline

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Investment decisions globally must account for exchange rate, political, economic, and cultural risks.

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Costs and profits must be allocated appropriately for proper analysis.

© 2019 FlatWorld

Key Takeaways 

Capital budgeting for multinationals involves accounting for possible changes in exchange rates.

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Costs and profits must be allocated appropriately to each division of a company for proper profit/loss analysis.

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Additional risk factors from multinational exposure include economic, institutional and political factors.

Key Terms 

Repatriated: To send back to the home country.

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Transfer pricing: Allocation method used to attribute profits and costs of divisions of a company to each other.

Answers to Exercises

1. If the peso appreciates, then the value of the fixed amount of pesos received will be higher, improving the “bottom line” of the parent company. The opposite is the case if the peso depreciates.

2. It can, through transfer pricing, although government regulators often set limits on how much is allowed or when it is allowed.

Section 6. The Bigger Picture  

Consider the ethical issues which arise by doing business internationally.

Explain the differences between Fair and Free Trade.

Section Outline © 2019 FlatWorld

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Care must be taken to value all stakeholders, not just shareholders.

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Fair trade is the idea specifically valuing workers as a stakeholder.

Key Takeaways 

Ethical consideration arises in international finance such as fairness and equity.

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Fair trade is the idea that workers in the developing country should be paid a fair wage.

Answers to Exercises

1. In considering all stakeholders, our employees and owners might benefit from the profits from the increased lobbying, but our customers or suppliers might be harmed due to the higher prices.

2. Answers will vary, based upon the costs borne by stakeholders: customers might have to pay more under “fair trade”, but suppliers get more.

Section 7. End-of-Chapter Problems Answers to Exercises

1. 0.79 £ 2. If the pound appreciates 15%, then the new exchange rate will be $1.27*(1+.15)=$1.461 = 1£, or $1 = 1/1.461 = 0.68£ 3. 15*$0.15=$2.25 4. 1.30*1.15=1.495 € for each 1 £, but euros have a higher precedence, so the quote will usually be given as 0.67 EUR/GBP 5. If the euro appreciates, then the value of the fixed amount of euros received will be higher, improving the “bottom line” of the parent company. The opposite is the case if the euro depreciates.

6. One dollar will buy more euros if the euro depreciates.

© 2019 FlatWorld

7. Answers will vary. In an industrialized or emerging country, economic risks include a slowdown in aggregate demand or supply shocks, political risks could include changing laws or tax rates, and cultural risks could include misunderstandings between managers and employees.

8. Economic risk. It might be positive if customers in China have more money to buy product. It might be negative for suppliers if there is increasing demand for their product in China.

9. Answers will vary based upon when the data is updated at The Economist.

10. Often, yes, due to the increased risk of operating abroad. But if the firms can also access capital in the foreign markets, then actually funding might be able to be secured at lower rates than domestic!

© 2019 FlatWorld

Chapter 19 Derivatives and Hedging How Do We Manage Risk? 

There are many risks involved with running a business. While most must be borne by the company, financial products exist which enable a firm to transfer risk to another party.

Section 1. Futures and Forwards 

Describe a forward contract and explain how it can help reduce risk.

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Explain how a future contract differs from a forward contract.

Section Outline  

A forward contract is an agreement to exchange an asset at a future time for a set price.

A futures contract is a standardized forward contract traded on an exchange.

Key Takeaways 

Forward and future contracts allow the reduction of risk by allowing parties to “lock-in” expected prices.

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Futures contracts are standardized and more liquid than forward contracts.

Key Terms    

Forward contract (or forward): An agreement to exchange an asset at a future time for a set delivery price.

Spot price: The current market price of an asset.

Underlying asset: The asset from which a derivative gets its value.

Derivative: Any financial assets which primarily derive their value from any other asset. © 2019 FlatWorld

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Counterparty risk: The potential exposure each party has to the other should they not be able to deliver their end of the contract.

Futures contract (or future): A standardized forward contract for certain assets traded on an exchange.

Answers to Exercises

1. Holding the gold is costly relative to a futures contract, and the futures contract could be more liquid.

Section 2. Options 

Describe an option contract and its properties.

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Explain the differences between an option contract and a futures contract.

Section Outline

An option gives the owner the right, but not the obligation, to buy or sell a security at a specified price. 

Call options give the owner the right, but not the obligation to buy the security.

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Put options give the owner the right, but not the obligation to sell the security.

Key Takeaways 

Options give the purchaser the right, but not the obligation to buy (for calls) or sell (for puts) an asset.

Key Terms

© 2019 FlatWorld

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Options: A derivative contract that gives the owner the right, but not the obligation, to buy or sell a particular security at a specified price until the contract expires.

Strike Price or Exercise Price: The specified price at which a security can be traded by the buyer of an option contract.

Calls: An option contract to buy the security for the specified price.

Puts: An option contract to sell the security for the specified price.

Premium: A payment for writing an option contract at the outset (that is, the price of the contract).

Warrants: Call options issued by the company to investors, usually as an incentive to purchase bonds or preferred securities.

Answers to Exercises

1. a. b. c. d.

Yes, since a call will increase in value if ABC rises.

No, since a call will increase in value if ABC rises.

No, since a put will decrease in value if ABC rises.

Yes, since a put will decrease in value if ABC rises.

Section 3. Convertible Securities 

Describe the features of a convertible bond.

Section Outline 

A convertible bond gives the owner of a bond the option to convert the bond into equity.

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Since a convertible bond is essentially a straight bond and a stock option, the coupon payments on a convertible bond are lower than the coupon payments on an equivalent straight bond.

Key Takeaways

© 2019 FlatWorld

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Convertible bonds and preferred stock give investors the option to “convert” their holdings into common stock at a pre-set conversion factor.

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Since the option to convert is valuable, convertible bonds typically have lower coupon rates than equivalent straight bonds.

Key Terms 

Convertible bond: A debt instrument that gives the owner the option to forego the repayment of the debt in exchange for equity in the company.

Answers to Exercises

1. More likely, since investors might be willing to trade the interest payments for the increased upside potential of the stock.

Section 4. Hedging Risk  

Explain how derivatives can be used to alter a company’s risk.

Describe some ways hedging can be done internally.

Section Outline 

Derivatives can be used to hedge potential risk.

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Firms will hedge to reduce the volatility of future cash flows.

Key Takeaways 

Derivatives can be used to alter the risks a business faces. Lower risks typically mean greater value.

© 2019 FlatWorld

Key Terms 

Hedging: Actions that reduce risk (often by reducing potential volatility in the firm’s cash flows).

Answers to Exercises

1. If the company takes a short position on a precious metal futures contract, then the short position will gain money when the price of precious metals fall (and vice-versa). Since they mine gold, the value of their product goes up when the price of precious metals rise (and vice-versa), so the short position gains in value when the product loses value (and vice-versa), thus reducing risk.

2. This problem should have been in section 19.3. Since the option to convert is valuable, investors will be willing to accept a smaller interest payment from the convertible bond relative to a straight bond. By issuing the convertible bond, the cash-strapped company will be able to make lower interest payments.

Section 5. The Bigger Picture  

Explain how hedging fits into the bigger picture of managerial finance.

Describe some of the ethical issues involving derivatives.

Section Outline 

While derivatives can be used to reduce risk, they can also be used by speculators.

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Excessive speculation can potentially lead to price dislocations and in extreme cases, asset bubbles.

Key Takeaways 

Derivatives help companies and investors to adjust their risk profiles.

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A derivative is like a sharp knife—a valuable tool when used properly, but it has the potential to be a weapon or to cause unanticipated harm if used improperly. © 2019 FlatWorld

Answers to Exercises

1. Purchasing wheat futures might cause the price of future wheat to rise, which might hurt starving populations. The more likely scenario, however, is that the higher wheat futures price will incentivize farmers to plant more wheat, making more wheat available, which will reduce hunger.

Section 6. End-of-Chapter Problems

Answers to Exercises

1. a. No, since a long futures position will lose value if the market crashes. b. Yes, since a short futures position will gain value if the market crashes. c. No, since the calls will lose value if the market crashes. d. Yes, since the calls will lose value if the market crashes. e. Yes, since the puts will gain value if the market crashes. f. No, since the puts will gain value if the market crashes.

2. The straight bonds, since the interest payment is likely to be higher. The convertible bonds have a higher upside potential, but if the company is unlikely to have a large upside, the higher interest payments are better.

3. If we buy Grapefruit Electronics puts or sell their calls, then our position will gain value when their stock loses value. Since their stock is correlated with the performance of our company, then the position will hedge our performance.

© 2019 FlatWorld

Chapter 20 Mergers, Acquisitions and Divestitures Greater Than the Sum of the Parts 

In 1995, Michael Eisner, the CEO of Disney at the time, said 1+1=4.

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In business, a firm wants to create synergies to capitalize on opportunities to grow their business or cut costs by combining with other firms. Firms frequently do this through mergers and acquisitions.

Section 1. Mergers and Acquisitions 

Explain the terminology of mergers.

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Explain the different ways to merge.

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Describe the ways to counter a merger.

Section Outline   

A merger is the combination of two firms. They may take place for a number of reasons.

Mergers may be friendly or hostile.

If a firm does not wish to merge or be acquired they may take one of several possible antitakeover measures.

Key Takeaways 

Mergers take place for many reasons including strategy, financial and subsidiary.

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Mergers can be vertical, horizontal or conglomerate.

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Firms can defend against mergers by recapitalizing or attempting to takeover the acquiring firm.

Key Terms © 2019 FlatWorld

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Merger: When two or more firms join together to make a single entity.

Acquisition: The purchase of something.

Target firm: The firm being purchased or merged.

Acquiring firm: The firm doing the purchasing or acquiring.

Consolidation: When two join to create a new corporation.

Strategic mergers: A merger done to achieve economies of scale.

Economies of scale: Increased efficiencies and reduced costs from larger operations.

Financial mergers: A merger undertaken to restructure the companies to improve their financial position.

Statutory mergers: When one firm is completely absorbed into another firm.

Subsidiary mergers: When the absorbed firm remains a separate entity.

Friendly mergers: When a merger is approved by the target firm.

Tender offers: A structured purchase of the target’s shares where the acquirer announces publicly that they are interested in purchasing.

Takeover: When one entity takes control of another.

Hostile merger: When the target firm does not want to be acquired by the acquiring firm.

Horizontal mergers: Between two firms in the same line of business.

Vertical mergers: Between two firms where one is a supplier to another.

Conglomerate mergers: A merger between two firms in unrelated lines of business.

Recapitalize: When a company changes its capital structure to make it less attractive for a takeover or merger.

Poison pills: When the target firm creates securities that give their holders certain rights if the firm is taken over.

White knight: When the target firm finds a friendly firm to acquire them.

Shark repellents: Anti-takeover amendments to a corporate charter.

Golden parachutes: Payments to key employees in the case of a takeover.

Greenmail: When the target firm repurchases a large block of stock from shareholders to end a hostile takeover from those shareholders.

Pac-Man defense: When the target firm tries to acquire the acquiring firm.

Just-Say-No defense: The target firm refuses to be taken over.

Answers to Exercises

1. Answers will vary. Reasons to merge include: strategic mergers that take advantage of economies of scale, financial mergers, horizontal mergers, vertical mergers, and conglomerates. Firms might also merge for political reasons.

Section 2. Leveraged Buyouts

© 2019 FlatWorld

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Describe a leveraged buyout.

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Explain a divesture.

Section Outline 

In an LBO, the acquiring firm uses a large amount of debt to finance the purchase.

Key Takeaways 

An LBO is a way to takeover a firm using a large amount of debt and not a lot of cash.

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A divestiture is to sell some of the firm’s assets.

Key Terms   

Leveraged buyouts (LBO): A way to purchase a company using a large amount of debt and not a lot of capital.

Divestitures: Selling a firm’s assets for strategic purposes.

Spin-off: When a parent company creates a new company with one of its divisions or units.

Answers to Exercises

1. An LBO allows a company to go private without having access to a lot of cash. It does increase leverage, which can make the company more vulnerable to adverse market conditions.

2. Divestitures are usually strategic, as opposed to selling assets in the normal course of business.

Section 3. Reorganization and Bankruptcy 

Describe why firms may fail. © 2019 FlatWorld

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Explain Chapter 11 reorganization.

Explain Chapter 7 liquidation.

Section Outline

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A firm may use bankruptcy (Chapter 11) to reorganize, or it may use bankruptcy to liquidate (Chapter 7) the firm.

If the firm is liquidated, secured creditors take precedence, then unsecured creditors, then equity holders.

Key Takeaways 

When firms aren’t able to keep sufficient cash flows to pay their investors and remain a going concern, they may need to turn to bankruptcy protection to reorganize or, failing all else, liquidate the firm.

Key Terms       

Bankrupt: When a firm’s liabilities are greater than its assets.

Bankruptcy Reform Act of 1978: Current bankruptcy legislation about the rules for bankruptcy filings in the US. Chapter 11: Portion of Bankruptcy Act that covers reorganization for failing firms.

Debtor in possession (DIP): Term for firm that files bankruptcy reorganization and is in charge of the proceedings.

Chapter 7: Portion of Bankruptcy Act that covers liquidation of a failed firm.

Secured creditors: Creditors with an asset pledged as collateral.

Unsecured creditors: Creditors with no specific asset pledged as collateral.

Answers to Exercises

© 2019 FlatWorld

1. A company in Chapter 7 is not expected to survive the bankruptcy, whereas a company in Chapter 11 is a going concern. In Chapter 7, the assets are liquidated (sold), whereas Chapter 11 protects the company from debtors while it reorganizes.

2. Probably Chapter 11, since the better cash flows will allow the company to continue to operate, provided they can work out something in the short-term with their creditors.

Section 4. The Bigger Picture  

Describe what part mergers and acquisitions play in management decisions.

Evaluate the ethics of mergers, acquisitions, and bankruptcy.

Section Outline 

For a merger to succeed, there needs to be value creation, from both financial and management perspectives.

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Successful economic growth depends upon “creative destruction”, with capital fleeing from value destroying uses to firms that can use that capital productively.

Key Takeaways 

Not all mergers create value.

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Strategic bankruptcy is a tool that can either help or force investors and firms.

Section 5. End-of-Chapter Problems

Answers to Exercises

1. If the firm acquires a supplier, it is a vertical merger. If the firm acquires a competitor, it is a horizontal merger.

2. Antitakeover measures include: recapitalization, poison pills, white knights, greenmail, shark repellents, golden parachutes, the Pac-Man defense, and the Just-Say-No defense. © 2019 FlatWorld

3. $155 million is the most they should pay.

4. Yes! A strategic bankruptcy should be considered, at least as a bargaining chip to be used to negotiate with the investors.

5. She should prefer the reorganization, since the projected $6 million of value is larger than the 10%*$50 million = $5 million she will get if the company is liquidated.

© 2019 FlatWorld