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corporate finance core principles
Questions and Answers of
Corporate Finance Core Principles
Discuss how the Companies Act 2006 defines distributable profits in the UK.
Why do companies reorganise their capital structure when they have accumulated losses?
What factors would a loan creditor take into account if asked to bear some of the accumulated loss?
Explain a debt/equity swap and the reasons for debt/equity swaps, and discuss the effect on existing shareholders and loan creditors.Explain why companies hold treasury shares.
Discuss why a company might make a rights issue at a heavily discounted price and how equity share holders would be affected if they did not take up the issue.
Given the uncertainty inherent in the recognition of provisions or contingent liabilities, financial statements would be much more reliable if the existence of potential liabilities were disclosed,
Explain how the CPP model differs from the CCA model as a basis for making dividend decisions.
‘The IASB’s failure to decide on a capital maintenance concept is regrettable as users have no ideaas to whether total gains represent income or capital and are therefore unable to identify a
Explain the effect on the statement of financial position in Figure 1.13 if the non-current asset consisted of expenditure on industry-specific machine tools rather than a lease.Data in Figure 1.13
Explain why it is the user who should determine the information that the accountant collects, measures and reports, rather than the accountant who is the expert in financial information.
‘Yuji Ijiri rejects decision usefulness as the main purpose of accounting and puts in its place account-ability. Ijiri sees the accounting relationship as a tripartite one, involving the accountor,
‘It is essential that the information in financial statements has a prudent characteristic if the financial statements are to be objective.’ Discuss.
Explain why realised cash flow might not be appropriate for investors looking to predict future dividends.
Discuss why it might not be sufficient for a small business person who is carrying on business as a sole trader to prepare accounts on a cash flow basis.
‘Unrealised operating cash flows are only of use for internal management purposes and are irrelevant to investors.’ Discuss.
‘While accountants may be free from bias in the measurement of economic information, they cannot be unbiased in identifying the economic information that they consider to be relevant.’ Discuss.
The increase in people working as self employed in the gig economy where income is more uncertain and the increase in the level of household debt has led to individuals being unable to pay their
‘Cash flow accounting and accrual accounting information are both required by a potential share-holder.’ Discuss.
‘The asset measurement basis applied in accrual accounting can lead to financial difficulties when assets are due for replacement.’ Discuss.
‘Accrual accounting is preferable to cash flow accounting because the information is more relevant to all users of financial statements.’ Discuss.
‘Information contained in a statement of income and a statement of financial position prepared under accrual accounting concepts is factual and objective.’ Discuss.
The annual financial statements of companies are used by various parties for a wide variety of purposes. Discuss which of the three statements of income, financial position and cash flows would be of
Discuss how amounts are reported in a statement of financial position if the accounts are not prepared on a going concern basis.
If the Swiss franc depreciates against the U.S. dollar, can a dollar buy more or fewer Swiss francs as a result?
Discuss this statement: “Firms can control their accruals within fairly wide limits.”
Why are interest charges not deducted when a project’s cash flows are calculated for use in a capital budgeting analysis?
When two mutually exclusive projects are being compared, explain why the short-term project might be higher ranked under the NPV criterion if the cost of capital is high whereas the long-term project
What types of projects require the least detailed and the most detailed analysis in the capital budgeting process?
Briefly discuss special factors associated with the following areas of multinational working capital management:(1) Cash management(2) Credit management(3) Inventory management
Briefly describe special problems that occur in multinational capital budgeting, and describe the process for evaluating a foreign project. Now consider the following project: A U.S. company has the
What is interest rate parity? Currently, you can exchange 1 euro for 1.27 dollars in the 180 day forward market, and the risk-free rate on 180-day securities is 6% in the United States and 4% in
Consider the following illustrative exchange rates.(1) Are these currency prices direct quotations or indirect quotations?(2) Calculate the indirect quotations for euros and kronor (the plural of
What are the six major factors that distinguish multinational financial management from financial management as practiced by a purely domestic firm?
Barnes’s cash budget for the entire year, although not given here, is based heavily on his forecast for monthly sales. Sales are expected to be extremely low between May and September but then to
What might SKI do to reduce its cash without harming operations? In an attempt to better understand SKI’s cash position, Barnes developed a cash budget. Data for the first 2 months of the year are
Calculate the firm’s cash conversion cycle given that annual sales are $660,000 and cost of goods sold represents 90% of sales. Assume a 365-day year.
Barnes plans to use the preceding ratios as the starting point for discussions with SKI’s operating executives. He wants everyone to think about the pros and cons of changing each type of current
Barnes plans to use the preceding ratios as the starting point for discussions with SKI’s operating executives. He wants everyone to think about the pros and cons of changing each type of current
Describe the recapitalization process and apply it to PizzaPalace. Calculate the resulting value of the debt that will be issued, the resulting market value of equity, the price per share, the number
With the preceding points in mind, now consider the optimal capital structure for PizzaPalace.(1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and
Now, to develop an example that can be presented to PizzaPalace’s management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing,
(1) What is business risk? What factors influence a firm’s business risk?(2) What is operating leverage, and how does it affect a firm’s business risk? Show the operating break-even point if a
What are stock splits and stock dividends? What are the advantages and disadvantages of each?
Describe the series of steps that most firms take when setting dividend policy.
Suppose SSC has decided to distribute $50 million, which it presently is holding in very liquid short-term investments. SSC’s value of operations is estimated to be about $1,937.5 million, and it
Discuss the advantages and disadvantages of a firm repurchasing its own shares.
(1) Describe the procedures a company follows when it make a distribution through dividend payments.(2) What is a stock repurchase? Describe the procedures a company follows when it make a
(1) Assume that SSC has completed its IPO and has a $112.5 million capital budget planned for the coming year. You have determined that its present capital structure (80% equity and 20% debt) is
(1) What is meant by the term “distribution policy”? How has the mix of dividend payouts and stock repurchases changed over time?(2) The terms “irrelevance,” “dividend preference, or
List three provisions in the corporate charter that affect takeovers.
What is the EROIC of each division for 5% growth and for 6% growth? How is this related to intrinsic MVA?
KFS has two divisions. Both have current sales of $1,000, current expected growth of 5%, and a WACC of 10%. Division A has high profitability (OP = 6%) but high capital requirements (CR = 78%).
KFS is also interested in applying value-based management to its own divisions. Explain what value-based management is.
The second acquisition target is a privately held company in a growing industry. The target has recently borrowed $40 million to finance its expansion; it has no other debt or preferred stock. It
The first acquisition target is a privately held company in a mature industry owned by two brothers, each with 5 million shares of stock. The company currently has free cash flow of $20 million. Its
The first acquisition target is a privately held company in a mature industry owned by two brothers, each with 5 million shares of stock. The company currently has free cash flow of $20 million. Its
The first acquisition target is a privately held company in a mature industry owned by two brothers, each with 5 million shares of stock. The company currently has free cash flow of $20 million. Its
The first acquisition target is a privately held company in a mature industry owned by two brothers, each with 5 million shares of stock. The company currently has free cash flow of $20 million. Its
List the two types of assets that companies own.
(1) Assume Shrieves’s average project has a coefficient of variation in the range of 0.2 to 0.4. Would the new line be classified as high risk, average risk, or low risk? What type of risk is being
Assume that Sidney Johnson is confident in her estimates of all the variables that affect the project’s cash flows except unit sales and sales price. If product acceptance is poor, unit sales would
(1) What is sensitivity analysis?(2) Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital for the project. Assume each of these variables can vary from its base-case,
(1) What are the three types of risk that are relevant in capital budgeting?(2) How is each of these risk types measured, and how do they relate to one another?(3) How is each type of risk used in
Calculate the after-tax salvage cash flow.
Estimate the required net working capital for each year and the cash flow due to investments in net working capital.
Define “incremental cash flow.”(1) Should you subtract interest expense or dividends when calculating project cash flow?(2) Suppose the firm had spent $100,000 last year to rehabilitate the
In an unrelated analysis, you have the opportunity to choose between the following two mutually exclusive projects:The projects provide a necessary service, so whichever one is selected is expected
As a separate project (Project P), you are considering sponsorship of a pavilion at the upcoming World’s Fair. The pavilion would cost $800,000, and it is expected to result in $5 million of
(1) What is the payback period? Find the paybacks for Franchises L and S.(2) What is the rationale for the payback method? According to the payback criterion, which franchise or franchises should be
What does the profitability index (PI) measure?What are the PI's of Franchises S and L?
(1) Define the term modified IRR (MIRR). Find the MIRRs for Franchises L and S.(2) What are the MIRR’s advantages and disadvantages vis-à-vis the regular IRR? What are the MIRR’s advantages and
(1) What is the underlying cause of ranking conflicts between NPV and IRR?(2) What is the reinvestment rate assumption, and how does it affect the NPV-versus-IRR conflict?(3) Which method is the
(1) Draw NPV profiles for Franchises L and S. At what discount rate do the profiles cross?(2) Look at your NPV profile graph without referring to the actual NPVs and IRRs. Which franchise or
(1) Define the term internal rate of return (IRR). What is each franchise’s IRR?(2) How is the IRR on a project related to the YTM on a bond?(3) What is the logic behind the IRR method? According
1) Define the term net present value (NPV). What is each franchise’s NPV?(2) What is the rationale behind the NPV method? According to NPV, which franchise or franchises should be accepted if they
(1) Harry Davis estimates that if it issues new common stock, the flotation cost will be 15%. Harry Davis incorporates the flotation costs into the DCF approach. What is the estimated cost of newly
What are three types of project risk? How can each type of risk be considered when thinking about the new division’s cost of capital?
What is the cost of equity based on the over-own-bond- yield-plus-judgmental-risk-premium method?
(1) What is the estimated cost of equity using the discounted cash flow (DCF) approach?(2) Suppose the firm has historically earned 15% on equity (ROE) and has paid out 62% of earnings, and suppose
(1) What are the two primary ways companies raise common equity?(2) Why is there a cost associated with reinvested earnings?(3) Harry Davis doesn’t plan to issue new shares of common stock. Using
(1) What is the firm’s cost of preferred stock?(2) Harry Davis’s preferred stock is riskier to investors than its debt, yet the preferred’s yield to investors is lower than the yield to
(1) What is the firm’s cost of preferred stock?(2) Harry Davis’s preferred stock is riskier to investors than its debt, yet the preferred’s yield to investors is lower than the yield to
(1) What sources of capital should be included when you estimate Harry Davis’s weighted average cost of capital?(2) Should the component costs be figured on a before-tax or an after-tax basis?(3)
What is put–call parity?
In 1973, Fischer Black and Myron Scholes developed the Black-Scholes option pricing model (OPM).(1) What assumptions underlie the OPM?(2) Write out the three equations that constitute the model.(3)
Consider a stock with a current price of P = $27. Suppose that over the next 6 months the stock price will either go up by a factor of 1.41 or down by a factor of 0.71. Consider a call option on the
Consider Triple Play’s call option with a $25 strike price. The following table contains historical values for this option at different stock prices:(1) Create a table that shows (a) stock price,
Options have a unique set of terminology. Define the following terms: (1) Call option (2) Put option (3) Strike price or exercise price (4) Expiration
What is a financial option? What is the single most important characteristic of an option?
What is the Efficient Markets Hypothesis, what are its three forms, and what are its implications?
If equilibrium does not exist, how will it be established?
What is market multiple analysis?
Now suppose that Temp Force’s earnings and dividends are expected to decline by a constant 6% per year forever—that is, g = −6%. Why would anyone be willing to buy such a stock, and at what
What would the stock price be if the dividends were expected to have zero growth?
Now assume that the stock is currently selling at $30.29.What is its expected rate of return
Assume that Temp Force is a constant growth company whose last dividend (D0, which was paid yesterday) was $2.00 and whose dividend is expected to grow indefinitely at a 6% rate. (1) What is the
(1) Write out a formula that can be used to value any stock, regardless of its dividend pattern.(2) What is a constant growth stock? How are constant growth stocks valued?(3) What happens if a
(1) Suppose investors raised their inflation expectations by 3 percentage points over current estimates as reflected in the 8% T-bill rate. What effect would higher inflation have on the SML and on
(1) Write out the Security Market Line (SML) equation, use it to calculate the required rate of return on each alternative, and then graph the relationship between the expected and required rates of
The expected rates of return and the beta coefficients of the alternatives, as supplied by Barney Smith’s computer program, are as follows:(1) Do the expected returns appear to be related to each
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