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fundamentals of financial management

Questions and Answers of Fundamentals Of Financial Management

What is discounting, and how is it related to compounding? How is the future value equation (Equation 5.1) related to the present value equation (Equation 5.2)?Equation 5.1Equation 5.2 Future value =
How does the present value of a future payment change as the time to receipt is lengthened? As the interest rate increases?
Suppose a U.S. government bond promises to pay $2,249.73 three years from now.If the going interest rate on 3-year government bonds is 4%, how much is the bond worth today? How much is it worth today
How much would $1,000,000 due in 100 years be worth today if the discount rate was 5%? If the discount rate was 20%?
The U.S. Treasury offers to sell you a bond for $585.43. No payments will be made until the bond matures 10 years from now, at which time it will be redeemed for $1,000.What interest rate would you
Microsoft earned $1.42 per share in 2007. Ten years later in 2017 it earned $3.08.What was the growth rate in Microsoft’s earnings per share (EPS) over the 10-year period? If EPS in 2017 had been
How long would it take $1,000 to double if it was invested in a bank that paid 6% per year? How long would it take if the rate was 10%?
Microsoft’s 2019 earnings per share were $5.06, and its growth rate during the prior 10 years was 12.06% per year. If that growth rate was maintained, how long would it take for Microsoft’s EPS
What’s the difference between an ordinary annuity and an annuity due?
Why would you prefer to receive an annuity due for $10,000 per year for 10 years than an otherwise similar ordinary annuity?
For an ordinary annuity with five annual payments of $100 and a 10% interest rate, how many years will the first payment earn interest? What will this payment’s value be at the end? Answer this
Assume that you plan to buy a condo 5 years from now, and you estimate that you can save $2,500 per year. You plan to deposit the money in a bank account that pays 4% interest, and you will make the
Why does an annuity due always have a higher future value than an ordinary annuity?
If you calculated the value of an ordinary annuity, how could you find the value of the corresponding annuity due?
Assume that you plan to buy a condo 5 years from now, and you need to save for a down payment. You plan to save $2,500 per year (with the first deposit made immediately), and you will deposit the
Why does an annuity due have a higher present value than a similar ordinary annuity?
If you know the present value of an ordinary annuity, how can you find the PV of the corresponding annuity due?
What is the PVA of an ordinary annuity with 10 payments of $100 if the appropriate interest rate is 10%? What would the PVA be if the interest rate was 4%?What if the interest rate was 0%? How much
At the beginning of your freshman year, your favorite aunt and uncle deposit $10,000 intoa 4-year bank certificate of deposit (CD) that pays 5% annual interest. You will receive themoney in the
Your grandfather urged you to begin a habit of saving money early in your life. He suggestedthat you put $5 a day into an envelope. If you follow his advice, at the end of the year youwill have
You just won the Florida lottery. To receive your winnings, you must select ONE of the twofollowing choices:1. You can receive $1,000,000 a year at the end of each of the next 30 years.2. You can
You just received your first credit card and decided to purchase a new Apple iPad.You charged the iPad’s $500 purchase price on your new credit card. Assume thatthe nominal interest rate on the
Sawyer Corporation’s 2020 sales were $5 million. Its 2015 sales were$2.5 million.a. At what rate have sales been growing?b. Suppose someone made this statement: “Sales doubled in 5 years. This
You want to buy a house that costs $140,000. You have $14,000 for a down payment, but your credit is such that mortgage companies will not lend you the required $126,000. However, the realtor
Simon recently received a credit card with an 18% nominal interest rate. With the card, he purchased an Apple iPhone 11 for $700. The minimum payment on the card is $20 per month.a. If Simon makes
It is now December 31, 2020 (t = 0), and a jury just found in favor of a woman who sued the city for injuries sustained in a January 2019 accident.She requested recovery of lost wages plus $300,000
A father is now planning a savings program to put his daughter through college. She is 13, plans to enroll at the university in 5 years, and should graduate 4 years later. Currently, the annual cost
Answer the following questions:a. Assuming a rate of 10% annually, find the FV of $1,000 after 5 years.b. What is the investment’s FV at rates of 0%, 5%, and 20% after 0, 1, 2, 3, 4, and 5 years?c.
You have applied for a job with a local bank. As part of its evaluation process, you must take an examination on time value of money analysis covering the following questions:a. Draw time lines for
What is the price paid to borrow debt capital called?
What are the two items whose sum is the cost of equity?
What four fundamental factors affect the cost of money?
Which factor sets an upper limit on how much can be paid for savings?
Which factor determines how much will be saved at different interest rates?
How do risk and inflation impact interest rates in the economy?
What role do interest rates play in allocating capital to different potential borrowers?
What happens to market-clearing, or equilibrium, interest rates in a capital market when the supply of funds declines? What happens when expected inflation increases or decreases?
How does the price of capital tend to change during a boom? During a recession?
How does risk affect interest rates?
If inflation during the last 12 months was 2% and the interest rate during that period was 5%, what was the real rate of interest? If inflation is expected to average 4% during the next year and the
Write an equation for the nominal interest rate on any security.
Distinguish between the real risk-free rate of interest, r*, and the nominal, or quoted, risk-free rate of interest, rRF.
How do investors deal with inflation when they determine interest rates in the financial markets?
Does the interest rate on a T-bond include a default risk premium? Explain.
Distinguish between liquid and illiquid assets, and list some assets that are liquid and some that are illiquid.
Briefly explain the following statement: Although long-term bonds are heavily exposed to interest rate risk, short-term T-bills are heavily exposed to reinvestment rate risk. The maturity risk
Assume that the real risk-free rate is r* = 2% and the average expected inflation rate is 3% for each future year. The DRP and LP for Bond X are each 1%, and the applicable MRP is 2%. What is Bond
What is a yield curve, and what information would you need to draw this curve?
Distinguish among the shapes of a “normal” yield curve, an “abnormal” curve, and a“humped” curve.
If the interest rates on 1-, 5-, 10-, and 30-year bonds are 4%, 5%, 6%, and 7%, respectively, how would you describe the yield curve? If the rates were reversed, how would you describe it?
How do maturity risk premiums affect the yield curve?
If the inflation rate is expected to increase, would this increase or decrease the slope of the yield curve?
If the inflation rate is expected to remain constant at the current level in the future, would the yield curve slope up, slope down, or be horizontal? Consider all factors that affect the yield
Explain why corporate bonds’ default and liquidity premiums are likely to increase with their maturity.
Explain why corporate bonds always yield more than Treasury bonds and why BBB-rated bonds always yield more than AA-rated bonds.
What key assumption underlies the pure expectations theory?
Assuming that the pure expectations theory is correct, how are expected short-term rates used to calculate expected long-term rates?
According to the pure expectations theory, what would happen if long-term rates were not an average of expected short-term rates?
Most evidence suggests that a positive maturity risk premium exists. How would this affect your calculations when determining interest rates?
Assume that the interest rate on a 1-year T-bond is currently 7% and the rate on a 2-year bond is 9%. If the maturity risk premium is zero, what is a reasonable forecast of the rate on a 1-year bond
Identify some macroeconomic factors that influence interest rates and explain the effects of each.
How does the Fed stimulate the economy? How does the Fed affect interest rates?
Does the Fed have complete control over U.S. interest rates? That is, can it set rates at any level it chooses? Why or why not?
If short-term interest rates are lower than long-term rates, why might a borrower still choose to finance with long-term debt?
Explain the following statement: The optimal financial policy depends in an important way on the nature of the firm’s assets.
Define each of the following terms:a. Production opportunities; time preferences for consumption; risk; inflationb. Real risk-free rate of interest, r*; nominal (quoted) risk-free rate of interest,
The real risk-free rate of interest, r*, is 3%, and it is expected to remain constant over time. Inflation is expected to be 2% per year for the next 3 years and 4% per year for the next 5 years. The
The yield on 1-year Treasury securities is 6%, 2-year securities yield 6.2%, 3-year securities yield 6.3%, and 4-year securities yield 6.5%. There is no maturity risk premium. Using expectations
An analyst is evaluating securities in a developing nation where the inflation rate is very high. As a result, the analyst has been warned not to ignore the cross-product between the real rate and
The real risk-free rate is 2.05%. Inflation is expected to be 3.05% this year, 4.75% next year, and 2.3% thereafter. The maturity risk premium is estimated to be 0.05 × (t - 1)%, where t = number of
Holt Enterprises recently paid a dividend, D0, of$2.75. It expects to have nonconstant growth of 18% for 2 years followed by a constant rate of 6% thereafter. The firm’s required return is 12%. a.
Investors require an 8% rate of return on Mather Company’s stock (i.e., rs = 8%). a. What is its value if the previous dividend was D = $1.25 and investors expect divi- dends to grow at a constant
Assume that today is December 31, 2021, and that the following information applies to Abner Airlines:● After-tax operating income [EBIT(1 2 T)] for 2022 is expected to be $400 million.● The
Assume that it is now January 1, 2022. Wayne-Martin Electric Inc. (WME) has developed a solar panel capable of generating 200% more electricity than any other solar panel currently on the market. As
In this chapter, we described the various factors that influence stock prices and the approaches that analysts use to estimate a stock’s intrinsic value. By comparing these intrinsic value
When calculating WACC, what capital is excluded and why?
When calculating a company’s WACC, should book value, market value, or target weights be used? Explain.
Why might the weights of capital be different depending on whether book values, market values, or target values are used?
Identify the firm’s three major capital structure components, and give their respective component cost and weight symbols.
Why might there be two different component costs for common equity? Which one is generally relevant, and for what type of firm is the second one likely to be relevant?
If a firm now has a debt ratio of 50% but plans to finance with only 40% debt in the future, what should it use as wd when it calculates its WACC? Explain.
Why is the after-tax cost of debt rather than the before-tax cost used to calculate the WACC?
Why is the relevant cost of debt the interest rate on new debt, not that on already outstanding, or old, debt?
How can the yield to maturity on a firm’s outstanding debt be used to estimate its before-tax cost of debt?
A company has outstanding 20-year noncallable bonds with a face value of $1,000, an 11% annual coupon, and a market price of $1,294.54. If the company was to issue new debt, what would be a
Is a tax adjustment made to the cost of preferred stock? Why or why not?
A company’s preferred stock currently trades at $80 per share and pays a $6 annual dividend per share. Ignoring flotation costs, what is the firm’s cost of preferred stock?
Why must a cost be assigned to retained earnings?
What three approaches are used to estimate the cost of common equity? Which approach is most commonly used in practice?
Identify some potential problems with the CAPM.
Which of the two components of the DCF formula, the dividend yield or the growth rate, do you think is more difficult to estimate? Why?
What’s the logic behind the bond-yield-plus-risk-premium approach?
Suppose you are an analyst with the following data: rRF = 5.5%, rM - rRF = 6%, b = 0.8, D1 = $1.00, P0 = $25.00, g = 6%, and rd = firm’s bond yield = 6.5%. What is this firm’s cost of equity
What are the two approaches that can be used to adjust for flotation costs?
Would a firm that has many good investment opportunities be likely to have a higher or a lower dividend payout ratio than a firm with few good investment opportunities?Explain.
A firm’s common stock has D1 = $1.50, P0 = $30.00, g = 5%, and F = 4%. If the firm must issue new stock, what is its cost of new external equity?
Suppose Firm A plans to retain $100 million of earnings for the year. It wants to finance its capital budget using a target capital structure of 46% debt, 3% preferred, and 51% common equity. How
Write the equation for the WACC.
Firm A has the following data: Target capital structure of 46% debt, 3% preferred, and 51% common equity; tax rate = 25%; rd = 7%; rp = 7.5%; rs = 11.5%; and re = 12.5%.What is the firm’s WACC if
Name three factors that affect the cost of capital and are beyond the firm’s control.

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