Liquidity Ratio in Capital Structure and Leverage

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How does financial accounting contribute to financial management?

By preparing financial statements that financial management uses to analyze the company’s health and make appropriate decisions.

What is the main focus of financial management in business finance?

Selection and best effective utilization of funds to a more profitable manner.

Explain the significance of economics in financial decision-making.

Economics refers to the socio-economic environment affecting business operations, including factors like supply and demand, inflation rate, economic downturn, and past economic conditions.

What is the role of accounting in tracking money flow?

Accounting tracks money flow for businesses and individuals, providing information and data from the past to present for better decision-making. Signup and view all the answers

Why are both economics and accounting considered vital for businesses and governments?

They help in planning for the future, making sound financial decisions, and formulating fiscal policies. Signup and view all the answers

What is the purpose of financial ratio analysis in financial statements?

To analyze financial performance using ratios and common-size financial statements. Signup and view all the answers

What is the formula for calculating Return on Equity (ROE)?

Net Income / Stockholder's Equity Signup and view all the answers

How does a higher ROE than the industry average impact a company's stock price?

A higher ROE than the industry average would be preferred by stockholders, and would have a great positive impact on the company's stock price. Signup and view all the answers

What does the Return on Assets (ROA) ratio determine?

The ROA ratio determines how much profit the company is making using the assets it has, and gives the company's efficiency in using its assets. Signup and view all the answers

What is the formula for calculating Return on Sales (ROS)?

Net Income / Sales Signup and view all the answers

What does a ROS result lower than the industry average mean?

If the company has a ROS result lower than the industry average, it means the company is doing worse than its competitors. Signup and view all the answers

What does the Basic Earning Power (BEP) ratio show?

The BEP ratio shows the raw earning power of the company without getting influenced by its taxes and leverage (Debt). Signup and view all the answers

What is the purpose of liquidity ratios?

Liquidity ratios provide an idea of a company's ability to pay its debts as they become due, such as interest payments, loan payments, accounts payable, and others. Signup and view all the answers

How is the current ratio calculated, and what does it indicate?

The current ratio is calculated as Current Assets / Current Liabilities. A higher current ratio compared to the industry average indicates a higher liquidity rate, which is good for the company. Signup and view all the answers

What is the purpose of the quick acid test ratio, and how is it calculated?

The quick acid test ratio, calculated as (Current Assets - Inventory) / Current Liabilities, assumes that inventory may be difficult to convert into cash quickly, so it removes inventory from current assets to assess the company's liquidity position. Signup and view all the answers

What are asset management ratios, and what do they indicate?

Asset management ratios, also known as efficiency ratios, show how well a company is managing its assets. Signup and view all the answers

What is the inventory turnover ratio, and what does it measure?

The inventory turnover ratio, calculated as Sales / Inventory, measures how well a company is managing its inventory against its sales. Signup and view all the answers

Why is it important to compare a company's liquidity and asset management ratios with industry averages?

Comparing a company's liquidity and asset management ratios with industry averages helps determine whether the company's performance is good or bad relative to the industry standard. Signup and view all the answers

What is the formula used to calculate the cost of retained earnings (Ks) using the Capital Asset Pricing Model (CAPM)?

Ks = Rf + (Km - Rf) × bi, where Rf is the risk-free rate, Km is the expected market return, and bi is the beta of the company's stock. Signup and view all the answers

What are the two main challenges mentioned in computing the cost of retained earnings using CAPM?

<ol> <li>Calculating the expected market return (Km), and 2) Determining the beta (bi) of the company's stock.</li> </ol> Signup and view all the answers

What are the two types of returns that common stockholders look for from retained earnings, according to the Discounted Cash Flow (DCF) approach?

<ol> <li>Dividends yield, and 2) Capital gains.</li> </ol> Signup and view all the answers

What is the formula used to calculate the cost of retained earnings (Ks) using the DCF approach?

Ks = (D1/Po) + g, where D1 is the expected dividend at the end of year 1, Po is the current stock price, and g is the expected growth rate of the company. Signup and view all the answers

If a company's stock is currently trading at $20, and it is expected to pay a $1 dividend at the end of the year with a 5% expected growth rate, what would be the cost of retained earnings using the DCF approach?

Ks = (1/20) + 0.05 = 0.10 or 10% Signup and view all the answers

What additional cost does a company incur when issuing new common stock, according to the text?

A company incurs a floatation cost when issuing new common stock. Signup and view all the answers

What is the formula for calculating the Weighted Average Cost of Capital (WACC)?

The formula for calculating WACC is: WACC = (Wd * Kd * (1 - T)) + (Wp * Kp) + (Ws * Ks), where Wd is the weight of debt, Kd is the cost of debt, T is the effective tax rate, Wp is the weight of preferred stock, Kp is the cost of preferred stock, Ws is the weight of common stock, and Ks is the cost of common stock. Signup and view all the answers

Explain the concept of a hurdle rate in the context of capital budgeting.

The hurdle rate is the minimum required rate of return that a project must meet or exceed in order to be accepted by the company. It is typically set equal to the company's WACC, and projects that are riskier than the company's average would use a higher hurdle rate, while lower-risk projects would use a lower hurdle rate. Signup and view all the answers

What are the three forms of funding mentioned in the text, and what are their respective weights in the company's capital structure?

The three forms of funding mentioned are: 50% debt, 10% preferred stock, and 40% common stock (in the form of retained earnings). Signup and view all the answers

Calculate the Weighted Average Cost of Capital (WACC) using the information provided in the text.

The WACC is calculated as: WACC = (50% * 8% * (1 - 40%)) + (10% * 9%) + (40% * 10%) = 2.4% + 0.9% + 4% = 7.3%. Signup and view all the answers

Explain why the company would use a hurdle rate higher than its WACC for a riskier project, and a hurdle rate lower than its WACC for a lower-risk project.

The text states that the WACC only applies to projects of average risk for the company. For riskier projects, the company would use a higher hurdle rate, and for lower-risk projects, the company would use a lower hurdle rate. This is because WACC needs to be adjusted for the risk of the specific project being evaluated. Signup and view all the answers