Managerial Finance Final Exam
What affect does inflation have on bond prices or interest rates for new or existing bonds? The price of bonds on the market can be either higher or lower than the face value of the bond depending on the current economic condition or the market condition, which can affect the price investors are willing to pay (Fidelity Investments, 2012). In regard to price, the bond prices are provided in terms of a percentage of par value.
The price investors are willing to pay can be greatly affected by the current interest rates. For example, if interest rates inflate after the bonds are issued, the prices on the existing bonds will usually fall (Fidelity Investments, 2012). This happens because new bonds are often issued with higher coupon rates as interest rates increase, which makes the older outstanding bonds less attractive unless they can be purchased at a lower price resulting in lower prices for existing bonds (Fidelity Investments, 2012).
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The inverse is true when interest rates decline, which means investors can sometimes sell a bond for greater than the purchase price when interest rates go down since other investors are willing to pay a premium for a bond with a higher interest payment or coupon rate (Fidelity Investments, 2012). Inflation also leads to a higher interest rates, therefore inflation has the same effect as interest rates: when inflation rises, the price of a bond tends to drop (Fidelity Investments, 2012).
A fixed-rate bond’s coupon rate normally remains unchanged for the life of the bond, so the bond may not be paying enough interest to stay ahead of inflation (Fidelity Investments, 2012). The longer a bond’s maturity, the greater the odds of inflation eventually lowering the bond price. For this reason, long term bonds often attract buyers by using higher interest rates to combat the fear of a rising inflation rate (Fidelity Investments, 2012).
Topic 5: Why is floatation cost included in computing the cost of capital for new stock issues? Floatation cost is defined as the cost associated with issuing new stocks or bonds (Barron’s Finance & Investment Dictionary, 2012). As is the case with most everything in life, there is an associated cost – and so it is with the issuance of stocks as well. The amount of underwriting risk and the physical distribution associated with the issuance of the stock causes the floatation cost to vary (Barron’s Finance & Investment Dictionary, 2012).
Floatation cost comprises the following two elements: “(1) the compensation earned by the investment bankers (the underwriters) in the form of the spread between the price paid to the issuer (the corporation or government agency) and the offering price to the public, and (2) the expenses of the issuer (legal, accounting, printing, and other out-of-pocket expenses)” (Barron’s Finance & Investment Dictionary, 2012). The key variable in floatation cost is the underwriting spread, which historically ranges from as low as 1. 5% of the par value of high-grade bonds to 23. 7% of the size of a small issue of common stock (Barron’s Finance & Investment Dictionary, 2012). Both negotiation and competition in bidding are factors in determining the underwriting spread (Barron’s Finance & Investment Dictionary, 2012). For these issuances to be profitable to the issuing companies, these floatation costs must be recovered through the issuing price of the stocks or bonds being sold.
The Securities and Exchange Commission (SEC) reports that underwriter’s compensation (spread) is the largest component of floatation costs and that “floatation costs are higher for small business issuers for reasons unrelated to regulation” (Securities and Exchange Commission, 1996). The SEC also suggests that lower direct costs could produce lower costs of capital (Securities and Exchange Commission, 1996). Topic 7: Discuss the concept of Optimal Capital Structure.
Optimal Capital Structure is defined as being the best debt-to-equity ratio for a firm that maximizes its value (Investopedia, 2012). The optimal capital structure for a company is one that offers a balance between the ideal debt-to-equity range and minimizes the firm’s cost of capital (Investopedia, 2012). Debate has ensued in regard to the relationship between the capital structure and the value of an individual firm as to whether there is an “optimal capital structure for the individual firm or whether the proportion of debt usage is irrelevant to the individual firm’s value (Hatfield, 1994).
Much research has surrounded the relationship between industry and capital structure. With this research, a relationship between industry and capital structure has been documented with the following determinants of capital structure being enveloped in these different firm characteristics: non-debt tax shields, research & development, advertising, individual products, and fixed assets, to name a few (Hatfield, 1994).
Research which followed almost 200 firms for a period of five years led to the overall finding that “the relationship between a firm’s debt level and that if its industry does not appear to be of concern to the market” (Hatfield, 1994). With the lack of significance of control of anticipated growth for each of the firms followed, there does not seem to be a definable argument for optimal capital structure within a corporation that can increase its value by moving toward the industry’s debt average (Hatfield, 1994).
Topic 8: Why is the Payback method often used in evaluating project proposal? According to our textbook, Foundations of Financial Management, there are two primary reasons why small business firms would choose to use an unsophisticated approach such as the Payback method to determine budget analysis (Block, Hirt, & Danielsen, 2009). The first reason is that the Payback method is simple and easy to determine and understand.
Because the small businessperson’s skills are more likely to be in customer relations, human resources, and product knowledge, it is assumed that the small business manager may be less likely to be educated in more complicated financial projections or cash flow methods that would typically be utilized by large business firms (Block, Hirt, & Danielsen, 2009). Secondly, because small business owners primarily deal directly with finance companies or bankers rather than stockholders, the focus of the loan investment is on their demonstrated ability to pay back the loan within a certain timeframe ather than to be up-to-date on their company’s internal rate of return or net present value (Block, Hirt, & Danielsen, 2009). For a small business, the payback method is most often used not only because of its simplicity, but because it provides the most relevant information for the intended use of obtaining the finances required for any upcoming project proposed for which finances would be obtained. Topic 10: Discuss the concept of Capital Rationing. Is this something a corporation should or should not do?.
Capital rationing is the technique used when a company has limited funds to invest in profitable investment proposals, so they incorporate a strategy to make investments based on their current relevant company circumstances (Kumar, 2010). For example, when a company has a limited amount of investment cash, the company will research investment profitability options and only invest in the combination of projects that not only remains within the set budget for investments, but will also most likely provide the intended return over the designated investment period (Kumar, 2010).
The two most common methods of capital rationing are “forbidding investments over a certain amount or increasing the cost of capital for such investments (Farlex, Inc. , 2012). Companies most often utilize capital rationing when they have had trouble with the performance of previous investments (Farlex, Inc. , 2012). The main goal of capital rationing is to protect the company from over-investing their assets (Financial Web, 2012). If over-investment occurred, the company might continue to see low return on investment and even face a compromised financial position.
The main benefit of capital rationing is budgeting a company’s corporate resources. When a company issues stock or borrows money, it can use these resources for new investments. However, if the company does not see a good return on investments, it is wasting these resources (Financial Web, 2012). By capital rationing, which is the process of increasing the cost of capital, the company can make sure it takes on fewer projects and only projects for which the anticipated return on investment is high (Financial Web, 2012).
Barron’s Finance & Investment Dictionary. (2012, November 26). Floatation Cost. Retrieved from Answers Corporation: http://www. answers. com/topic/flotation-cost Block, S. B. , Hirt, G. A. , & Danielsen, B. R. (2009). Foundations of Financial Management, Thirteenth Edition. New York: McGraw-Hill Irwin. Farlex, Inc. (2012, November 26). Capital Rationing. Retrieved from The Free Dictionary by Farlex: http://financial-dictionary. thefreedictionary. com/Capital+Rationing Fidelity Investments. (2012, November 26). Bond prices, rates and yields. Retrieved from Fidelity. om: https://www. fidelity. com/learning-center/fixed-income-bonds/bond-prices-rates-yields Financial Web. (2012, November 26). What is Capital Rationing? Retrieved from The Independent Financial Portal Financial Web: http://www. finweb. com/financial-planning/what-is-capital-rationing. html Hatfield, G. B. (1994). The Determination of Optimal Capital Structure: The Effect of Firm and Industry Debt Ratios on Market Value. Journal of Financial and Strategic Decisions, Volume 7, Number 3. Investopedia. (2012, November 26). Optimal Capital Structure.
Retrieved from Investopedia US: http://www. investopedia. com/terms/o/optimal-capital-structure. asp#axzz2DM76dXcn Kumar, V. (2010, March 11). Capital Rationing. Retrieved from Accounting Education: http://www. svtuition. org/2010/03/capital-rationing. html Securities and Exchange Commission. (1996, July 30). Appendix A: The Impact of the Current Regulatory System on Investor Protection and Capital Formation. Retrieved from Securities and Exchange Commission: News and Public Statements: http://www. sec. gov/news/studies/capform/appa0721. txt