Finance Question Answers

7.1 Distinguish between debentures and mortgage bonds.

Debenture are unsecured long term debts and much more risky than secured bonds. On the other hand, mortgage bonds are secure bonds against property usually. The people who hold mortgage bonds have been provided with the margin of safety by the bond issuers.

7-2. Define (a) Eurobonds, (b) zero coupon bonds, and (c) junk bonds.

A Eurobonds, as the name suggest, are the bonds that are issued in the euro zone. These bonds dominate the European euro zones i.e. the countries that use Euro as their currency.

The Zero Coupon bonds do not pay periodic interests to the people who have them.

Junk Bonds, as the name suggest literally means that you might be throwing your money away when you buy these bonds. They have then highest risks associated with them.

7-4. a. How does a bond’s par value differ from its market value? b. Explain the differences among a bond’s coupon interest rate, current yield, and required rate of return.

1. Bond’s par value is an arbitrary value that the company that issues these bonds may predict for the bond. While the actual market value is the value with which they are sold in the open market. The market value keeps on changing with new currency rates and other financial and economic indicators.
2. Coupon interest rate is the rate to calculate percentage of the par value of the bond.

While the current yield is the ratio of the interest rate to the bond’s current market price.

The required rate of return is the minimum rate of return that an investor will expect and be willing to purchase the assets.

8-1. Why is preferred stock referred to as a hybrid security? It is often said to combine the worst features of common stock and bonds. What is meant by this statement?

Due to the fact that preferred stock has the properties of both stock and bonds, it is called a hybrid security. It is similar to common stocks and bonds because just like common stocks and bonds, it also has a fixed maturity date and its dividends are not deductible for tax.

8-3. Why would a preferred stockholder want the stock to have a cumulative dividend feature and protective provisions?

For a certain degree or protection, preferred stockholders want the stock to have a cumulative dividends.

In there is a non-payment of dividends, the protective provisions provide the stakeholders a voting rights. With protective provisions, the stakeholders can restrict the payments of common dividends.

9-1. Define the term cost of capital.

Cost of capital is the cost of making a choice for the coming opportunity. Companies might utilize it by keeping the finances for future opportunities and not returning them to the investors.

9-2. In 2009, ExxonMobil (XOM) announced its intention to acquire XTO Energy for $41 billion. The acquisition provided ExxonMobil an opportunity to engage in the development of shale and unconventional natural gas resources within the continental United States. This acquisition added to ExxonMobil’s existing upstream (exploration and development) activities. In addition to this business segment, ExxonMobil was also engaged in chemicals and downstream operations related to the refining of crude oil into a variety of consumer and industrial products. How do you think the company should approach the determination of its cost of capital for making new capital investment decisions?

There are two activities that XOM engages in. The first activity is the exploration and development. The second is chemical and downstream operations. Both these business activities have their own potentials and risks. These risks are reflected in the cost of capital as the company makes new investments in acquisition. Therefore, the company must have a strategy that deals with risks and opportunities at two different levels. Company should apply segment wise cost of capital in conducting acquisition of new assets.

9-3. (Cost of equity) In the spring of 2015, the Brille Corporation was involved in issuing new common stock at a market price of $35. Dividends last year were $1.50 and are expected to grow at an annual rate of 5 percent forever. Flotation costs will be 6 percent of market price. What is Brille’s cost of equity for the new issue?

(Mathematical)

Why is capital budgeting such an important process? Why are capital budgeting errors so costly?

Capital budgeting are important because the capital of a company is what would let it acquire new assets. If there are mishandlings of the capital budgeting, it would have severe consequences in the long and short term for the company. The company might get on to new assets which is not worth what it was budgeted for. Huge amount of capital might be going out of the finances of a company with capital budgeting, the errors made in it can be catastrophic.

11-1. Why do we focus on cash flows rather than accounting profits in making our capital-budgeting decisions? Why are we interested only in incremental cash flows rather than total cash flows?

Due to the fact that accounting profits may not provide a clear picture of the benefits and cost on a timely basis, cash flows are utilized to make capital budgeting decisions.

Incremental cash flows can tell the accountants exactly what they can use to pay their debts at what time. On the other hand, total cash flow does not provide this information. Total cash flow may deal to a full fiscal year not its instances.

11-2. If depreciation is not a cash-flow expense, does it affect the level of cash flows from a project in any way? Why?

Depreciation is not a cash flow expense as it is involved with the depreciated value of assets that were purchased at different times in a project. The net income usually understates cash flow by the amount of depreciation. The depreciation is added back only when the cash flow calculations are complete. Therefore, depreciation may not affect the level of the cash flow.

Problem 11-2. (Consideration of sunk and opportunity costs) Hewlett-Packard has designed a new type of printer that produces professional-quality photos. These new printers took 2 years to develop, with research and development running at $10 million after taxes over that period. Now all that’s left is an investment of $22 million after taxes in new production equipment. It is expected that this new product line will bring in free cash flows of $5 million per year for each of the next 10 years. In addition, if HewlettPackard goes ahead with the new line of printers, the current production facility for the old printers that are to be replaced with this new line could be sold to a competitor, generating $3 million after taxes.

1. How should the $10 million of research and development be treated?
2. How should the $3 million from the sale of the existing production facility for the old printers be treated?
3. Given the information above, what are the cash flows associated with the new printers?

 

(Mathematical)

 

12.2 Distinguish between business risk and financial risk. What each type of risk?

Business risks relates to the variability of an organizations Earnings Before Interest and Taxes (EBIT) while financial risks are acquired from the financial information of an organization. Financial risks are utilized to make a comparison of organizations.

Depending on the nature of an organization, the business risk may vary.  For example the cost structure may have associated business risks. On the other hand the liabilities of a firm like debts can have financial risks.

12-3. Define the term financial leverage. Does the firm use financial leverage if preferred stock is present in its capital structure?

Organizations use different kinds of securities. Some these securities have fixed rates which are called financial leverages. Companies may use margin accounts to borrow as their financial leverages. Financial leverages may also be achieved by the use of debts.

12-4. Define the term operating leverage. What type of effect occurs when the firm uses operating leverage?

Fixed operating costs are incurred in incomes streams to achieve operating leverage. It is the measure of the growth of the operating income resulted from revenue growth in an organization. Operating leverages results in a rapid rise of an organization’s EBIT due to the rise of its sales.