Additional Study Guide (1) PDF

How do you calculate the change in retained earnings? Net Income-Dividends Which of the following is generally true? Operating income and EBIT are the same EBIT=Earnings before interest and taxes. Used to measure a firm’s operating income. Which components are part of total assets? Cash accounts rec...

How do you calculate the change in retained earnings? Net Income-Dividends Which of the following is generally true? Operating income and EBIT are the same EBIT=Earnings before interest and taxes. Used to measure a firm’s operating income. Which components are part of total assets? Cash accounts receivable, inventory, long-term assets Which components are part of current assets? Inventory, cash, accounts receivable, short-term investments Which components are part of total liabilities? Bonds, accounts payable, mortgage Why is the balance sheet known as a permanent statement? Because the other statements reset at the end of the fiscal year A basic equation for the balance sheet is? Equity = Assets – Liabilities When fixed assets increase, what happens to cash? Cash decreases Which is the purpose of the statement of cash flows? Explains the change in cash balance for a period of time. The OIROI (Operating Income Return on Investment) uses what elements on the income statement? EBIT, Total Assets Why would a company be interested in the TAT (Total Asset Turnover) ratio? How efficient assets are at producing sales Which of the following gives the largest effective rate (APY-annual percentage yield)? 18.6% compounded daily What does the beta coefficient represent? It is a statistically-derived measure of volatility Why is depreciation expense taken out of the net income calculation yet added back at the end? Because depreciation expense is tax deductible Why is the NPV preferred over the IRR? It measures the dollar value. It is more reliable. What does the degree of Financial leverage indicate? The reliance on debt If a company has a high degree of financial leverage, what does that tell us about the firm’s risk profile? Higher profits to shareholders What is the cash cycle? The amount of time to regenerate cash Why is float important to understand? The time cash expenditures What should a company do to manage its working capital? Collect quickly and pay slowly What would be a source of information to determine replacement cost? Building Appraisal What does the Sarbanes-Oxley Act require companies to do? Have internal control audits FINRA (Financial Industry Regulatory Authority) does the following: Prosecutes naughty stockbrokers If a product is made 100% domestically, what can affect its domestic market? International competition If a company makes its product in a foreign country where labor costs are much lower, what happens? Profits go up and domestic employment decreases If the value of a dollar increases, the price of imports: Decreases Why would a farmer buy a hedge when he signs a contract to sell produce Overseas? To reduce currency risk Suppose the inventory turnover of a company is higher than the industry. Based on this observation, which of the following is most likely? The firm has too little inventory resulting in lost sales or stock-outs If the company wishes to obtain a bank loan, will it want to have higher current ratio or a lower current ratio? Higher If an investor knows the idiosyncratic risk, the investor knows the: Beta coefficient Why would we reject a project based on the NPV (Net present value)? The NPV is a negative number Why would we reject a project based on the IRR (internal rate of return)? The discount rate is higher than the IRR Company A wishes to keep 20% of its assets as cash. Company B keeps its cash balance at 5% of assets. Which of the following statements apply? Company B invests in more working current assets Company A offers trade credit of 2% 10/ net 30 and company B offers trade credit at net 30. What can be said about the credit policies of each company? Company A can attract more customers Which of the following characterizes a collection float? Increased float indicates slower processing time Company A’s inventory is larger than Company B. Both companies are competitors and are about the same size. What does this difference mean from a working capital management standpoint? Company B might have higher inventory turnover In regards to Accounts payable balances, which of the following is true? Paying off A/P on the last day due is a good policy. If two companies have earnings of $2,000,000 and company X has a multiple of 1.2 and Company Z has a multiple of 2.0, what can we estimate about the value of each company? The value of company Z is higher Dodd-Frank regulates which segment of the US economy? Banking industry The SEC (securities and exchange commission) requires companies to do the following: Register all public offerings. Regulate stock sales Economics is a subfield of finance: True or False? False Capital is defined as a financial asset: True or False? True Stocks and bonds are 2 types of financial instruments: True or False? True Primary financial markets are markets where issuers place new securities with investors: True or False? True An IPO (initial public offering) occurs on the primary market: True or False? True An IPO is a seasoned equity offering: True or false? False Syndicates are generally made up of investment banks and other institutional investors: True or False? True While competitive sales allow underwriters to submit bids to purchase bonds, negotiated sales do not: True or False? False NASDAQ is the world’s largest secondary financial market: True or False? False Auction markets have a physical location: True or False? True Dealer Markets have physical location: True or False? False NASDAQ is an example of an auction market: True or false? False Stocks that are listed on dealer markets generally have a single dealer for each stock: True or False? False Markets are where prices are determined: True or False? True The NYSE specialist has an objective to provide liquidity to the market: True or False? True The NYSE specialist will charge a higher price to sellers of the stock and a lower price to the buyer of the stock: True or False? False The bid-ask spread is compensation to the specialist for providing liquidity to the market: True or False? True A market order to buy a stock would execute at the current ask rate: True or False? True A market order to sell a stock would execute at the current ask rate: True or False? True A limit order to buy a stock at $101.55 would execute at the current ask price: True or False? False A limit order to buy a stock at $101.55 would execute when the ask price is at or below $101.55: True or False? True Efficient markets are those in which prices are volatile: True or False? False Efficient markets will often have mispriced securities: True or False? False Inefficient markets are those in which prices will respond quickly to new information: True or False? False Because in an inefficient market all available information is built into the price of a stock, investment patterns and trends to “get rich quickly” are not easily discernible and it is difficult to predict the price: True or False? True In an inefficient market, prices will slowly respond to new information: True or False? True In an efficient market, new information will move prices almost immediately: True or False? True What is the relationship between WACC (weighted average cost of capital) and IRR (internal rate of return)? IRR must exceed WACC to accept investment What is the relationship between NPV (Net present Value) and IRR (Internal rate of return)? If discount rates equals IRR, NPV is equal to zero If a firm's financial and operating leverage is high, what is the implication? Profits are more volatile as sales fluctuate. If an industry, such as autos, has very high fixed costs and very cyclical sales, what is the implication for financial leverage? Use low financial leverage to offset high operating leverage The SGR measures: Potential sales growth with internal funding The SEC requires public companies to do the following: File audited financial statements to the SEC What does the Sarbanes-Oxley Act require companies to do? Have internal audit Controls If a company produces and sells a product only in the US, what international developments may affect its sales? Imports of competing products The SEC requires the following to file audited financial statements: All publicly-traded companies Which best describes conceptually the valuation of all financial assets in financial markets? The NPV of anticipated cash flows Which accurately describes an “efficient” market? Deviations from “fair value” are quickly eliminated If a firm's goal is to maximize stockholder wealth, which would the firm avoid? Investments with negative NPV If you wanted to evaluate a non-public company, what sources would you use? The PE of a comparable public company Which section of the statement of cash flows describes the production and sales of the firm’s product? Cash Flow operations For calculating cash flows, why is depreciation added to net income? Depreciation is a non-cash deduction The fundamental concept underlying the valuation of all financial assets is: The present value of anticipated cash flows What explains the size of the yield spread of junk bonds over treasury? It is the value of the expected default loss What does the beta measure? The relative riskiness of an individual stock What is the most effective use of financial statements in valuing a stock? Use data to estimate future earnings If market interest rates rise, what impact does it have on a given bond? Its price decreases What impact did the recent corporate tax cut have on a firm's WACC (weighted average cost of capital)? It increased WACC Why do firms often use “sensitivity” tests in analyzing investment projects? Uncertainty of forecast assumptions If debt is less costly than equity, why don’t firms maximize debt use? Excessive debt increases risk of bankruptcy Why does a firm's investment opportunities affect its dividend payout ratio? Maximization of shareholder wealth strategy. Limited access to market financing. Attempts to increase stock price. If two annuities have the same payments and term, why is an Annuity Due more valuable than an Ordinary Annuity? Annuity Due payments occur earlier What is the impact of rising interest rates on foreign exchange? Increases the value of USD In cash flow statements, which section reflects so-called “spontaneous” accounts which vary with sales? Cash flow operations What are the practical disadvantages of the Gordon model for equity valuation? How to use it if no dividends are paid. Must project dividends “forever” into the future. Does not address the appropriate discount rate. What factor determines the “market risk premium” on stocks? The investor-perceived riskiness of stocks Why would a company buy back outstanding stock? To boost the price of stock. To increase financial leverage. Lack of investment opportunities. Which factor does NOT affect the firm's WACC (weighted average cost of capital)? The exchange rate Why should an investor diversify the portfolio? To achieve a better combination of risk and return. To avoid putting “all eggs in one basket”. Stock returns are a function of systematic risk. Which statement about a PE ratio is false? Low PE stocks are cheap If a firm cannot access markets sufficiently to meet their DFN (discretionary financial need), what strategies might they use. Slow growth rate. Lower dividend payout. Increase in net margin. Dodd-Frank regulates which segment of the US economy? Banking industry Which is not true of both stocks and bonds? Have voting rights The value of a corporation is best measured by: Market capitalization Which is not a component of the DuPont formula? Debt to Equity Ratio What metric converts FV (Fair Value) to PV (Present Value)? The discount rate The interest rate on a corporate bond does not reflect: Face Value PV (present value) ordinarily is less than FV (fair value). What would cause the opposite? Negative Interest rates Which would likely have the lowest price? Zero coupon bond Junk bonds are those whose rating is below: BBB Diversification protects against: Idiosyncratic risk Which is the best diversification for stock investment? Auto company and grocery chain If you are assessing a firm's ability to meet short term obligations, you would use which ratio? Quick ratio To assess firm efficiency, which ratio would you use? Asset turnover Which would have the highest value? Gross Margin Which is the most important profit ratio? Return on equity If the debt ratio increases, what effect does that have on ROE (return on equity)? ROE increases What is one way a firm maximizes shareholder value? By avoiding investments that cost more money than they bring in What is one of the two basic types of financial instruments? Stocks Why is it a challenge for a fund manager to review financial statements from other countries? Because the US Generally Accepted Accounting Principles (GAAP) and the international financial reporting varies. What is true about the content and structure of an income statement? It reports the revenues and expenses for a period of time What is true when income for tax purposes is higher than accounting income? Actual incomes taxes payable will be higher than accounting income tax payable What does the statement of cash flows report? A firm's cash balance and changes for a period of time What does net income measure that the cash flow from operating activities does not? Payments made to supplies of goods and services Which measure of cash flow is commonly used to evaluate the change in revenue and costs? Cash flow from operating expenses An analyst is comparing the ratios of two firms and needs to address accounting differences. What would be considered an accounting difference between the two firms? The firms use different inventory methods For the year 2013, a firm has a return on equity (ROE) that is greater than return on assets (ROA). Which conclusion would an analyst draw from these numbers? The firm is effectively using debt What is an example of an estimate used in recording transactions? Deciding the salvage value of a fixed asset when calculating depreciation expense What is the coupon rate (Yield) of a bond? The interest rate of the bond that is contractually set upon issuance If the coupon rate on a particular bond is higher than the market rate of a return, at what will the bond sell? At a premium Which securities are issued by the US federal government and are taxable at the federal level? Treasury bonds What is the current price of the bond, if the required rate of return on a bond is the same as the coupon rate? Equal to the par value of the bond If the current coupon rate on a bond is 6% and the bond is selling at a 5% discount, what is the yield to maturity of the bond? Equal to 6% How is a short term receivable, with the maturity of less than one year, carried on the balance sheet? As a current asset When is a company that has strong operating revenues and competent management a good investment? When the intrinsic value of the price per share is higher than the current stock price Thinking about levels of market efficiency quadrants. Which investment option should be selected assuming a prudent investor wants to maximize their expected return E(R)? Quad 1?; Quad 2? Quad 3? Quad 4? Quad 1 Which security type includes the right to vote for a board of directors? Common stock What makes the “efficient frontier” efficient? It maximizes the ratio expected return to risk What are 3 components required in calculating weighted average cost of capital (WACC)? The marginal tax rate. The value of preferred stock and debt. The firm's market value. What advantage does the Gordon growth model have compared to the capital asset pricing model (CAPM)? It provides an easier to understand and relatively accurate forecast when growth rates are stable How does the weighted average cost of capital affect a company’s growth Opportunities? The lower the cost of capital, the greater the growth opportunities Under which 3 conditions would a firm decide to reduce growth rate? When additional investor capital is not available. When capacity has been reached. When customers are dissatisfied with the company’s products. Which 3 changes would affect an estimate of differential cash flows? An increase in the estimated value of the new machine at the end of a project. A revision in the depreciation schedule. An increase in the overhead allocation. Why is it important to prepare an accurate fixed asset financing forecast? Firms producing above capacity may not require additional fixed asset investment to increase sales How is the value of a project determined in the capital budgeting process? The net present value of the incremental tax cash flows Company A has a high degree of business risk. What will be the effect on the company’s EBIT if the company suffers a slight decrease in sales? Large decrease in EBIT What effect does the method of financing investments have on the value of the firm? The method of financing alters the weighted average of the cost of capital Why would a company prefer equity financing over debt financing? Using equity to finance a capital investment project is less costly Which hybrid security has some elements that resemble equity and others that resemble debt? Preferred stock How do increases in market interest rates affect a firm's cost of capital? The cost of debt increases Which two ratios are used to evaluate a company’s working capital management? Receivable turnover. Cash ratio. Why should a company carry cash? Cash is needed for day-to-day operations What is a commonly used method that limits the time it takes between payment and the receipt of cash? Electronic check processing Some companies offer discounts to customers as an incentive to pay earlier than the due date. What two terms incentivize customers to accept trade discounts? Length of credit period. Amount of discount. Which 3 costs are associated with holding inventory? Storage costs, product costs, opportunity costs Which ratio is used in the comparable multiples method? Price earnings ratio Investors will often sell a stock that has gains rather than a stock that is suffering losses in their portfolio, despite subsidized tax relief when selling at a loss. What are the logic-defying behavioral implications of such a stock decision? Maintaining winning positions in the portfolio enhances future portfolio growth rate How are the Security and exchange commission’s Regulation S and Rule 144A similar? Both allow firms to raise capital without registering with the SEC if certain conditions are met What is the primary intent of the Sarbanes-Oxley Act? To ensure honest audit and accounting procedures Which element is required disclosure in the prospectus, according to the Securities Act of 1933? Audited Financial Statements Which condition must be met for a firm that trades in equities to be in compliance with the SEC regulations? Membership in FINRA (Financial Industry Regulatory Authority) Which practice is limited by the Volcker rule of the Dodd-Frank Act? Bank investments in hedge funds What is beta? An absolute measure of systematic risk What do investors, entrepreneurs and other market participants rely on the SEC to do? Determine safety and efficiency of investment by US and foreign investors What is one way a firm maximizes shareholder value? By avoiding investments that cost more money than they bring in What is one of the two basic types of financial instruments? Stocks The stock price of a company increases and the market is deemed efficient. What assumption can be made? A new, patented product was introduced to the market Which statement is true about how the global market affects the US? Foreign investors and fund managers make decisions based on financial reporting standards developed and financial statements audited overseas. What are secondary markets? Markets where securities are traded subsequent to the initial offering A special interest group in the US has been lobbying intensely for protectionism through increased tariffs and trade restrictions, with the argument that it will save jobs in the industry they represent. What is the most likely result if they are successful? Employees and shareholders of the domestic industry that produce the protected goods will benefit and the nation will be hurt What is true about the content of an income statement? It reports revenues and expenses for a period of time What is the basis used to compute a company’s income tax expense? Taxes payable A company’s trial balance shows $900 in long term debt. On which financial statement should this be shown? The balance sheet What do cash flows from financing activities generally relate to? A firm's debt and equity transactions What is true about the cash flow from operating activities section of the statement of cash flows? Increase in current liabilities accounts represents inflow of cash and should be added to net income Firms A and B are in the same industry. Firm A has a gross margin of.45 and Firm B has a gross margin of.36. Which conclusion would an analyst draw when comparing Firm A to Firm B? Firm A has a more efficient production process What is subordinated debenture? A bond that has a lower claim to the assets of the firm in the event of liquidation What is the difference between a secured and an unsecured loan? Secured loans require some form of collateral What is the intrinsic value of a stock? Net present value of expected future cash flows What is the relationship between annual percentage rate (APR) and Annual percentage yield (APY)? The APR will be greater than the APY if compounding happens more frequently than annually What is the priority order of repayment (first to last) to a company’s investors and creditors? Creditors, preferred stockholders, common stockholders Where on the “efficient frontier” is a young investor with a high risk tolerance likely to fall? D3 Supply and demand factors suggest the slope for an individual asset in the portfolio will equal the slope of the market portfolio itself. What is the significance of this equalization? Investors will be incentivized to hold the market portfolio What are the components required in calculating the weighted average cost of capital (WACC)? The value of the preferred stock and debt. The firm's market value. The marginal tax rate. How does the WACC affect a company’s growth opportunities? The lower the cost of capital, the greater the grown opportunity What are discretionary accounts? Accounts that requirement management to deliberately decrease and increase What is the purpose of the capital budget process? Deciding which projects increase the firm's value Firm A has a lower degree of business risk that Firm B. What will happen if there is a 1% increase in sales from both firms? It will result in a greater percentage in Firm B’s operating income. Modigilani and Miller's initial capital structure theory suggested that in the absence of taxes, bankruptcy costs and transaction costs, the firm's capital structure would not affect the WACC. What has been proven by subsequent research and inclusion of factors omitted in the initial theory? The firm's capital structure does affect the weighted average cost of capital and thus a firm's value Which strategy issues new debt within a company and takes the proceeds from the debt issuance to buy back some of the outstanding shares? Leverage Recapitalization Which type of bond gives an investor the right to trade each bond for a set number of shares of common stock whenever the investor chooses? Convertible bond A credit agency recently downgraded a company’s debt. What is the impact on the cost of debt? The cost of capital will increase Which term describes the amount of cash that a firm must hold as a safety net to counter future unforeseen expenses? Reserve balance Which ratio is used in the comparable multiple’s method? Price earnings ratio What must a firm have to be in compliance with Financial Industry Regulatory Authority (FINRA) Rules? Current and accurate books A company's stock price increases and the market is deemed efficient. What assumption can be made? A new, patented, product was introduced to the market. B. New machinery was purchased with a useful life of 20 years. C. Management is optimizing itsresources and operating efficiently. D. Management hired new employees and invested in a training program. Which statement is true about how the global market affects the U.S. A. A bad options trade executed by a foreign subsidiary of a Wall Street bank will affect layoffs overseas. B. A Bad derivatives trade executed by a foreign subsidiary of a Wall Street bank will affect layoffs overseas. C. American investors and fund managers make decisions based on financial reporting standards developed and financial statements audited overseas. D. Foreign investors and fund managers make decisions based on financial reporting standards developed and financial statements audited overseas. What are secondary markets? A. Markets where securities are traded subsequent to the initial offering. B. Markets were securities are issued for the first time. C. Markets were securities are issued through a competitive sale. D. Markets where securities are issued through a negotiated sale. A special interest group in the U.S. has been lobbying intensely for protectionism through increased tariffs and trade restrictions, arguing that it will save jobs in the industry they represent. What is the most likely result if they are successful? A. Employees and shareholders of the domestic industry that produce the protective goods will be hurt, and the nation will benefit. B. The overall economy will benefit from trade restrictions and tariffs. C. Removing the trade restrictions and tariffs will result in a net economic loss to the overall U.S. economy. D. Employees and shareholders of the domestic industry that produces the protected goods will benefit, and the nation will be hurt. What are the content and structure of a balance sheet report? The assets , liabilities , and equity at a point in time What is the basis used to compute a company's income tax expense? A. Pretax accounting income. B. Taxable income. C. Net operating income. D. Taxes payable. Using the data below, what is the firm’s cash flow from financing? Net Income $1000, Depreciation Expense $300, Change in operating assets $600, Change in net PP&E $5000, Change in long-term Liabilities $1000, Dividends Paid $200 A. $200 outflow B. $800 outflow C. $800 inflow D. $1,000 inflow A company reported an increase in accounts payable of $2000 for the current year. Half of this amount is expected to be paid next period. How will this change in accounts payable be reported on the statement of cash flows? A. The change will increase cash flow from operations by $1000 B. The change will decrease cash flows from operations by $2,000 C. The change will decrease cash flows from operations by $1000 D. The change will increase cash flow from operations by $2000 A company's trial balance shows $900 in long-term debt. Which financial statement should show this? The balance sheet What do cash flows from financing activities generally relate to? A. A firm's purchase and sale of long-term assets B. A firm's non-cash transactions C. A firm's debt and equity transactions D. A firm's sale of goods and services What is true about the cash flow from the operating activities section of the statement of cash flows? A. Increases in current liability accounts represents an inflow of cash and should be added to net income B. Decreases in current liability accounts represent an outflow of cash and should be added to net income C. Increases in current liability accounts represent an outflow of cash and should be subtracted from net income D. Decreases in current liability accounts represent an inflow of cash and should be added to net income Partial financial data for a company is as follows. EBIT $250,000, Depreciation $10,000, Change in working capital $2,000, Net capital expenditures $3,000, Tax rate 30%. What is the company’s free cash flow? A. $255,000 B. $178,000 C. $180,000 D. $265,000 An analyst is comparing the ratios of two firms and needs to address accounting differences. What would be considered an accounting difference between the two firms? A. The firms have different auditors B. The firms use different inventory methods C. The firms have different fiscal years D. The firms are in different industries A company’s year-end balance sheet shows the following financial data. AR $200, Inventory $700, Fixed assets $500, Acct’s payable $500, Long term debt $1000. What is the company’s current ratio? Firms A and B are in the same industry. For 2013, Firm A has a gross margin of.45, and Firm B has a gross margin of.36. Which conclusion would an analyst draw when comparing Firm A to Firm B? A. Firm A has a more efficient production process B. Firm A has a higher depreciation expense C. Firm A has a lower depreciation expense D. Firm A has a less efficient production process What is an example of an estimate used in recording transactions? A. Deciding whether to expense or depreciate a fixed asset B. Deciding the salvage value of fixed asset when calculating depreciation expense C. Deciding the cost of a fixed asset when calculating depreciation expense D. Deciding whether to sell a fixed asset An investor anticipates receiving $72,000 in 6 years. Assuming an annual discount rate of 9%, what is the present value of this company? A. $42,616 B. $42,931 C. $60,000 D. $66,055 A doctor will receive $9,000 annually (at the end of the year) for 10 years. The annual interest earned on the investment is 6%. What is the present value of this doctor’s investment? A. $64,240 B. $66,241 C. $90,000 D. $118,627 A banker wants to retire 20 years from today and would like to have an annual income of $300,000 withdrawn at the end of each year 10 years starting in exactly 20 years. The discount rate is 6%. What is the present value today? A. $688,473 B. $2,208,026 C. $3,000,000 D. $3,441,000 What is a subordinated debenture? A. A bond that is backed by collateral B. A bond that has a lower claim to the assets of the firm in the event of liquidation C. A bond that has a higher claim to the assets of the firm in the event of liquidation D. a risk-free bond The market rate of return is 6%. The bond's face value is $1000, the coupon rate is 10% with annual compounding, and it matures in 15 years. What is the bond's value? A. $748 B. $1,000 C. $1,248 D. $1,294 At what will the bond sell If the coupon rate is higher than the market rate of return? A. At a premium B. A the risk-free rate C. At par D. At a discount A company issues bonds at a market price of $1,100. The face value is $1000. The bonds mature in 18 years, and the coupon rate is 6% compounded annually. What is the yield to maturity on this company’s bonds? A. 12.46% B. 10.00% C. 6.00% D. 4.72% Which securities are issued by the U.S. Federal government and are taxable at the federal level? A. Municipal bonds B. Eurobonds C. Treasury bonds D. Corporate bonds A $1,000 bond with a 5% coupon rate matures in 7 years. The expected return is 6%. Assuming annual compounding, what is the current value of the bond? A. $910.92 B. $1,057.86 C. $944.18 D. $1,000.00 The current coupon rate on a bond is 6%. And the bond is selling at a 5% discount. What is the yield to maturity on this bond? A. Greater than 6% B. Equal to 5% C. Equal to 6% D. Less than 6% What is the difference between a secured loan and an unsecured loan? A. Secured loans require some form of collateral. B. Unsecured loans require some form of collateral. C. Unsecured loans typically have a lower interest rate D. Secured loans typically have a higher interest rate 28. What is the intrinsic value of a stock? A. Past market value B. The future estimated market value C. The 100-day moving average of the stock price D. Net present value of expected future cash flows A broker purchases a stock that pays a $1.15 annual dividend at a price of $16.00. The broker expects a 15% rate of return. What is the total actual return if this broker sells this stock after one year for $19.00? A. 15.5% B. 18.4% C. 20.2% D. 25.9% A company recently paid an annual dividend of $2. Dividend growth is expected to be 5% What is the highest price a person should be willing to pay for one share of this company today if the person’s required return remains at 12%? A. $21.20 B. $30.00 C. $46.45 D. $55.00 What is the relationship between annual percentage rate (APR) and annual percentage yield (APY)? A. The APR will equal the APY if compounding happens more frequently than annually B. The APR will be less than the APY if compounding happens more frequently than annually C. The APR will be greater than the APY if compounding happens more frequently than annually D. The APR will be less than the APY if compounding happens more frequently than annually What is the priority order of repayment (first to last) to a company's investors and creditors? A. Creditors, common stockholders, preferred stockholders B. Creditors, preferred stockholders, common stockholders C. Preferred stockholders, creditors, common stockholders D. Common stockholders, preferred stockholders, creditors A company is planning a new product release. It estimates a 50% probability for a blockbuster result that will increase the price of the stock 30%. The probability the stock will remain unchanged is 25%. There is a probability the stock will drop by 5% What is the expected return of this new product release? A. 14% B. 25% C. 35% D. 41% Where on the "efficient frontier" is a young investor with a high-risk tolerance likely to fall? A. A1 B. C1 C. D2 D. D3 Supply and demand factors suggest the slope for an individual asset in the portfolio will equal the slope of the market portfolio itself. What is the significance of this equalization? A. The entire risk-return slope will decrease over time B. The slope of the individual assets in a portfolio will diverge to increase diversification. C. Investors will be forced to frequently shift their portfolios D. Investors will be incentivized to hold the market portfolio hat components are required to calculate the Weighted Average Cost of Capital (WACC)? Choose 3 answers A. The firm's market value B. The desired growth rate C. The market cap of the company D. The value of preferred stock and debt E. The amount and required return for common equity, preferred equity and debt F. The marginal tax rate G. The combined total expected growth rate A company has a total market value of $100 million, $30 million of which is short-term debt. The cost of that short-term debt was 4.5%. The company has a marginal tax rate of 40%. What is the weighted after-tax cost of short-term debt for the company? A. 30.1% B. 4.5% C. 1.35% D. 0.81% Which advantage does the Gordon Growth Model have compared to the capital asset pricing model (CAPM)? A. It requires assumptions about growth that benefit fast-growing companies B. It requires accurate known factors, such as future growth rates. C. It is highly accurate in predicting future growth D. It provides an easier-to-understand and relatively accurate forecast when growth rates are stable How does the weighted average cost of capital affect a company's growth opportunities? A. The higher the cost of capital, the greater the growth opportunities B. Only the cost of debt will affect growth opportunities C. The lower the cost of capital, the lower the growth opportunities D. The lower the cost of capital, the greater the growth opportunities A corporation's balance sheet shows $125 million in assets. Total liabilities are $94 million, and owner’s equity is currently $14 million. What is the corporation’s external discretionary financing need (DFN)? A. $14 million B. $17 million C. $32 million D. $80 million The year 2010 ending retained earnings were $5 million. The year 2011 forecasted net income is $1 million with a 10% dividend payout ratio. What are the forecasted retained earnings for the year 2011? A. $18,000 B. $20,000 C. $5.4 million D. $5.9 million Projected total assets are $1 million, with projected total liabilities of $500,000 and projected owner’s equity of $100,000. Which amount of discretionary financing is needed? A. $400,000 B. $600,000 C. $1.4 million D. $1.6 million Under which three conditions would a firm decide to reduce the growth rate? Choose 3 A. When additional investor capital is not available B. When customers are dissatisfied with the company's products C. When capacity has been reached D. When the company's borrowing limits have reached the maximum allowed by the lender E. When investors are dissatisfied with the dividend payout ratio The financial data for a company are as follows: Net Income $4,000,000 Sales $20,000,000 Assets $8,000,000 Dividends $2,000,000 Equity $5,000,000 Liabilities $3,000,000 What is this company's sustainable growth rate? A. 40% B. 50% C. 60% D. 100% A firm is evaluating a new product. If adopted, estimated sales will increase by $14,500,000 per year. Incremental variable and fixed costs are estimated to be $2,350,000. In addition, the new machine has an annual depreciation expense of $1,100,000. What is the estimated differential cash flow in year 1 if the tax rate is 40%? A. $6,280,000 B. $6,630,000 C. $7,290,000 D. $7,730,000 A company is considering a project with the following cash flows and a discount rate of 26%. Initial outlay ($5,000) Year 1 $3,000 Year 2 $3,500 Year 3 $3,200 Year 4 $2,800 Year 5 $2,500 What should this firm decide based on the net present value (NPV)? A. Reject the project since the NPV is negative B. Accept the project since the NPV is negative C. Reject the project since the NPV is positive D. Accept the project since the NPV is positive How will the value of a $1,000,000 capital budgeting investment be affected, assuming the inflation rate is 2%? A. The investment will be worth $500,000 in one year B. The investment will be worth $1,000,000 in one year C. The investment will be worth $1,020,000 in one year D. The investment will be worth $1,200,000 in one year What are discretionary accounts? A. Accounts that increase automatically with sales B. Accounts that appear only on an income statement C. Accounts that include current assets D. Accounts that require management to deliberately increase or decrease A company is replacing an old machine with a new one. This old machine is being sold for $200,000 and is valued at $50,000. The tax rate for the firm is 40%. What are the net proceeds from the sale of this old machine? A. $50,000 B. $140,000 C. $150,000 D. $260,000 What is the purpose of the capital budget process? A. Deciding which projects increase the firm's value B. Estimating the cost to start a new project C. Estimating the budget of a new project D. Budgeting a firm's monthly revenue and expenses The financial data associated with a company is listed below: Sales $1,350,000 Variable costs $375,000 Fixed costs $450,000 Interest expense $123,000 Depreciation Expense $0 What is this company’s degree of financial leverage? A. 1.0 B. 1.1 C. 1.2 D. 1.3 Firm A has a lower degree of business risk than Firm B. If sales increased by 1% for both firms, what would happen? A. a greater percentage increase in Firm B's operating income B. a greater percentage increase in Firm A’s operating income C. a greater percentage decrease in Firm A’s operating income D. a greater percentage decrease in Firm B’s operating income Modigliani and Miller's initial capital structure theory suggested that in the absence of taxes, bankruptcy costs, and transaction costs, the firm's capital structure would not affect the weighted average cost of capital (WACC). What has been proven by subsequent research and the inclusion of factors omitted in the initial theory? A. Financing decisions do not affect a firm's value B. Modigliani and Miller's initial work has proven accurate in determining a firm's value. C. Taxes are the only factor that impacts the weighted average cost of capital and a firm's value D. A firm's capital structure does affect the weighted average costs of capital and, thus a firm's value. 15.1 A Brief History of U.S. Government Financial Regulation LEARNING OBJECTIVES Government regulation has historically played a critical role in the development and operation of financial markets and institutions. A brief history will help set the context for the learning objectives of this topic. During the mid-1800s, the government had a somewhat laissez-faire attitude towards regulating financial institutions. As a result, "wildcat banking" led the federal government to institute the National Banking Act of 1863, which was one of the first cases of government regulation within the U.S. banking industry. 1 Describe the U.S. Securities and Exchange Commission (SEC) and its role in monitoring capital markets, including Rule 144A/Regulation S security types. 2 Determine whether company controls meet the requirements of the Sarbanes-Oxley Act. 3 Explain the relationship between the prospectus and the Securities Act of 1933. 4 Determine whether a company is in compliance with SEC and the Financial Industry Regulatory Authority (FINRA). 5 Describe the Dodd Frank Act and its role in monitoring capital markets. With the National Banking Act, regulation in America was born. This act was followed by the Federal Reserve Act of 1913, which was designed to curb a series of bank runs and recessions. Next, the McFadden Act of 1927 was designed to provide greater accessibility for bank customers. For example, it prohibited banks from establishing branches across state lines to deter customers from redeeming banknotes. Next, as a result of the Great Depression, the Glass-Steagall Banking Act of 1933 was designed to decrease the number of banks that were failing. The Glass-Steagall Act was significant because it limited banks in a fairly dramatic way. For example, banks were not allowed to underwrite risky securities, pay interest on checking accounts, or hold corporate debt or equity. The Glass-Steagall Act essentially set up a wall between commercial/consumer banking and investment banking. The next law passed was the Bank Holding Company Act of 1956 designed to further protect the banking industry from competition. In the late 1970s, inflation and a sluggish economy were the catalyst for the Depository Institutions Deregulation and Monetary Control Act of 1980. This Act was the beginning of a deregulation trend, which was hoped to help spur financial institutions and the economy. The next phase of deregulation was a response to the savings and loan (S&L) crisis of the early 1980s. The Garn-St. Germain Act of 1982 loosened restrictions on what financial institutions could do in the United States with regard to products they could offer. For example, it allowed banks to offer adjustable rate mortgages, money market deposit accounts, and investment in government bonds, and permitted healthy institutions to acquire failing institutions. The next major regulation was a result of a major deterioration in the banking industry and reversed the deregulation trend a bit. Called the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (or FIRREA for short), it dealt mostly with capital requirements. 15.2 Dodd Frank Act You will notice that government regulation of the banking industry is like a pendulum, first with little regulation in the wildcat days of the mid 1850s, to stiff regulation as a result of the Great Depression, back to a trend of deregulation as a result of the S&L crisis of the early 1980s, to the re-regulation of the SL fallout of the late 1980s, which continued into the late 1980s with the Federal Institutions Reform, Recovery, and Enforcement Act of 1989. This Act established risk-based insurance premiums for banks known as a CAMELS score (Capital adequacy, Asset quality, Management quality, Earnings, Liquidity, Sensitivity to market risk). After the 1989 Act, a wave of deregulation of institutions began again with the Reigle-Neal Interstate Branching and Banking Efficiency Act of 1994. Reigle-Neal allowed banks to transact business across state lines. Along with Reigle-Neal, the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 continued to deregulate the banking industry. The deregulation wave was then blamed for the financial crisis of 2008 and was the catalyst for the Dodd-Frank Act of 2010. Dodd-Frank was an aggressive step for re-regulation of the banking industry. For example, the repeal of the Glass-Steagall Act through mainly the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 was blamed for allowing financial institutions to become “too big to fail.” After the repeal of Glass-Steagall, many large financial holding companies held huge subsidiaries in commercial banking, investment banking, and insurance. It was argued that these gigantic financial institutions would collapse the economy if they were permitted to fail, and as such, the government provided massive bailouts that were controversial to the American public. Dodd-Frank was an attempt to regain control of the financial institutions industry by the federal government. The major pieces of Dodd-Frank were the creation of the Financial Stability Oversight Council to monitor how systematic risk could impact the industry. Dodd-Frank also expanded governmental authority to force liquidation of financial institutions, increased regulation of hedge funds, created the Federal Insurance Office to monitor the insurance industry, and instituted the “Volcker Rule," which limits bank investments in hedge funds and proprietary trading. The overall purpose of Dodd-Frank is to monitor capital markets through market analysis of systematic risk, increased scrutiny of the hedge fund industry, monitoring of the insurance industry, and limitations of investable assets of banks. In the history of banking and market regulation, Dodd-Frank is another instance of the regulatory pendulum swinging back to the side of increased regulation. 15.3 The Securities and Exchange Commission (SEC) The U.S. SEC was established by the Securities Exchange Act of 1934 as a response to the Wall Street crash of 1929 and the ensuing Great Depression. The SEC is the governmental oversight unit to enforce the statutes designed to regulate markets and protect investors. Some examples of these statutes are the Securities Act of 1933, the Trust Indenture Act of 1939, the Investment Company Act of 1940, the Sarbanes-Oxley Act of 2002 (to be covered later in this topic), and the Credit Rating Agency Reform Act of 2006. The SEC operationalizes its mission in two primary ways. First, it requires public disclosure of firm data for firms desiring to sell public equity or debt (or to non-accredited investors). There are several key filings that public companies make during their life cycles. When a firm desires to conduct an initial public offering (IPO), it files an original offering prospectus, known as SEC Form S-1 as well as the “red herring.” This form allows the firm to begin the process of going public, but the firm is not allowed to take any official offers to purchase shares until the actual IPO date. Once a firm is public, it must file quarterly (Form 10-Q) financial reports as well as the annual report (Form 10-K). There are a myriad of other forms dealing with insider sales of stock, procedural bankruptcy filings, and the like. Since 1994, firms have been required to file SEC documents online at the SEC EDGAR (Electronic Data Gathering, Analysis and Retrieval System). You can check out the site at edgar.sec.gov. One of the ways the Securities Act of 1933 allows firms to raise capital without going through the IPO process is Rule 144A. Rule 144A is known as a “safe harbor” from the registration requirement of the Securities Act of 1933. Rule 144A permits sale of private capital to accredited investors. Accredited investors, as defined by the SEC, are typically large financial institutions, or wealthy individuals. The cut-offs for individual investors to be considered accredited investors are (a) a net worth of $1 million (individual or joint with spouse) and (b) individual income of $200,000 per year or joint income of $300,000 income per year with spouse for the past two years and with the expectation of this year. (See http://www.sec.gov/answers/accred.htm for a full SEC definition.) Individuals only need to meet one of the requirements to be considered accredited. If a firm courts only accredited investors, then under Rule 144A, it may approach and sell securities (private placement) without full registration through the SEC. When a firm executes a private placement under Rule 144A, it typically prepares a private placement memorandum (PPM) to distribute to interested investors. The PPM provides enough information about the firm to satisfy private investor questions. Similar to Rule 144A, Regulation S is another safe harbor from the Securities Act of 1933. It allows raising capital without registering with the SEC; however, the securities must only be sold outside of the United States. Even U.S. entities and citizens physically located outside of the United States cannot invest under Regulation S. The rationale for the SEC reporting requirements is to protect U.S. investors; thus the prohibition of U.S. citizens investing inside or outside of the United States without full SEC registration. Because the SEC is primarily concerned with U.S. investors, it provides a safe harbor for U.S. firms to sell to foreign entities. 15.4 Securities Act of 1933 Mentioned above, the Securities Act of 1933 was a direct result of the Wall Street crash and Great Depression. With the exception of a few safe harbors, like Rule 144A and Regulation S explained above, the 1933 Act requires firms to fully register with the SEC before selling securities to the public. The primary document a firm files to go public is the prospectus, SEC Form S-1. This form is designed to provide any public U.S. citizen interested in investing in a firm sufficient information to make an informed decision. It is designed to mitigate fraud in the securities industry. The prospectus includes audited financial statement information, the name of the lead underwriter(s), a discussion about the firm and its prospects by management, the price of the offer, the number of shares being offered, and even a section of risk factors, among many other requirements. Insiders in the IPO are very careful to be fully transparent in the prospectus disclosure. If they leave out any material information (for example, in the risk factor section), it opens the firm up to legal liability. Lawsuits may be brought by investors or by the SEC. Legal action by the SEC is the second primary way it enforces its duty of regulating security markets and protecting investors from corporate fraud. When the initial S-1 is filed, it is typically a boilerplate document with a lot of specific data missing. As the SEC combs through the S-1 and as the firm and its underwriter “build the book” through what is known as the roadshow, the firm files amendments to the S-1, known as S-1/As. It is not uncommon for a firm to have several amendments before it actually goes public. The last amendment is usually the pricing amendment, which lists the exact price per share at which the stock will be offered to the primary market and is often filed the night before or the morning of the actual offer. When the firm initially is sold to the public, in the United States it is almost always done as what is known as a firm commitment offering. The underwriter, typically a large investment bank like Goldman Sachs, purchases all of the shares the firm is offering the public and then immediately sells them to the primary market. The primary market buys the shares at the offer price, which is listed in the final prospectus. The primary market is typically composed mostly of large institutional investors, but usually includes a smaller proportion of individual investors as well. Some primary market participants sell their shares on the first day to the secondary market and begin a liquid market for the stock on an exchange such as the New York Stock Exchange or NASDAQ. 15.5 Sarbanes-Oxley Act In the aftermath of Enron, perhaps the greatest firm failure based upon fraud to that point in history, Congress created the Sarbanes-Oxley Act of 2002. The idea of the Act, also known as SOX, was threefold. First, it was designed to ensure that public company boards of directors actually represented the shareholders in good faith. Second, it was designed to monitor company executives and ensure they were truthful in their SEC reporting. Third, SOX was designed to ensure that public accounting firms were being honest in their audits of public companies. The need for the threefold mission of SOX can be demonstrated with the Enron case. We will use this case, although other scandals and frauds such as Tyco, WorldCom, or HealthSouth could be used as well. Enron was a U.S. energy firm that eventually went bankrupt in 2001. Enron executives, primarily Chairman Kenneth Lay, CEO Jeffrey Skilling, and CFO Andrew Fastow, knowingly and strategically used accounting fraud to prop up the profits of Enron for almost a decade (1993–2001). The fraud was so elaborate, that it duped investment markets as well as the firm’s auditor, Arthur Andersen. Some argue that Arthur Andersen was actually complicit and point to the fact that Arthur Andersen was found guilty of obstruction of justice in 2002 for destroying documents related to the Enron audit. Though the Arthur Anderson conviction was dismissed by the Supreme Court in 2005, Arthur Andersen went out of business in a shock to the public accounting industry, and the “Big 5” accounting firms became the “Big 4” accounting firms with the demise of Arthur Anderson. As can be seen with Enron, 1) the board, under chairperson Lay, was guilty of fraud; 2) management, namely, CEO Skilling and CFO Fastow, were guilty of fraud; and 3) the auditor may have been guilty of fraud, but clearly destroyed evidence (at least a few Andersen employees did). SOX specifically targets these three areas by dictating significantly more severe punishment for financial fraud by the board or management, requiring top management to sign financial statements individually certifying their accuracy, and creating greater separation between outside accounting auditors and the firms they audit. Company controls must meet multiple key provisions of SOX. Firms must be concerned with information transparency, proper audits, disclosures of off-balance sheet items, internal assessment of corporate controls, non-retaliation against whistleblowers, and independence from U.S. enforcement agencies. The disclosure controls of Section 302, for example, require a set of internal control policies that can add significant expense to operating firms. Many firms find that the internal audits necessary to comply with SOX are too costly in terms of time and money. As a result of SOX, some analysts argue that many public firms have delisted to become private and others do not publicly list, or list internationally, to avoid the headaches of SOX. There were approximately 8,000 listed firms in the United States. After SOX, the number of public firms decreased nearly monotonically to fewer than 5,000 in 2011. Whether this decrease can actually be attributed to SOX is a matter for careful researchers to decide, but for our purposes, we just need to realize that complying with SOX can be costly to a firm. For additional information on SOX, see http://www.sec.gov/about/laws/soa2002.pdf. 15.6 Financial Industry Regulatory Authority (FINRA) In this subsection, we discuss a regulatory organization that acts much like a governmental agency, but is actually a private corporation. An SRO (self-regulatory organization), FINRA is itself overseen by the SEC. Thus, firms that are regulated by FINRA are ultimately overseen by the SEC as well. The primary substituents of FINRA are brokerage firms and exchange markets. FINRA is the largest independent regulating service for all securities firms operating within the United States. The overall mission of FINRA is to protect investors by ensuring the securities industry acts fairly and honestly with all investors. Does this sound familiar? This is similar to the role the SEC plays as a governmental agency. Companies that trade in equities, corporate bonds, financial futures, and options that are not regulated by another SRO, must be members of FINRA to be compliant with the SEC. Among the functions of FINRA are to license individuals, admit firms to the industry, write rules to govern their behavior, examine firms for regulatory compliance, and to discipline members that do not comply with federal securities laws or FINRA’s own rules. Along with these oversight roles, FINRA offers education opportunities for industry professionals, qualification exams, and outsourced regulatory products to various markets and exchanges. To determine if a firm is compliant with FINRA, the site http://finra.complinet.com/ is very useful. The site includes tabs for regulation, compliance, education, and enforcement. Under the compliance tab, information can be found for registering, regulatory filings, reporting, and market transparency. Official compliance examinations of firms and traders occur on a regular basis. From the FINRA website: Compliance Exams FINRA regularly examines all firms to determine compliance with FINRA's rules and those of the SEC and the Municipal Securities Rulemaking Board (MSRB). During a routine examination, FINRA examines those aspects of a firm's business that present heightened regulatory risk, as well as certain core areas. Specifically, FINRA examines a firm's books and records to see if they are current and accurate. FINRA analyzes sales practices to determine whether the firm has dealt fairly with customers when making recommendations, executing orders, and charging commissions or markups and markdowns, and scrutinizes a firm's anti-money laundering program, business continuity plans, and financial integrity and internal control programs. Similarly, firms go through a rigorous review for financial and operational compliance. Routine examinations also seek to determine each firm's compliance with the anti-fraud provisions of the Securities Exchange Act of 1934, the Securities Act of 1933, FINRA's advertising rules and Regulation T of the Federal Reserve Board, which governs the extension of credit (margin) by brokers and dealers Author’s Note: The authors would like to thank Dr. Colby Wright for information that significantly contributed to the first two sections of this topic. Information taken from government pages was also very instructive. For more details on governmental regulation, we encourage the interested reader to peruse http://www.sec.gov/.